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Tuesday, January 04, 2011 2:30 PM

S&P 500 PE Ratios Well Above Mean and Median Long-Term Averages; What's Next?

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Here is an interesting chart of long-term S&P 500 PE ratios courtesy of multpl.com. I added the annotations in red.

click on chart for sharper image

Two Key Points

1. In spite of what most cheerleaders suggest, this is one strenuously overvalued market.

2. In spite of the crash in 2008 and early 2009, valuations never reached typical bear market trough valuations.

From the FAQ:

The figures on this site are the PE10 or Shiller PE. They are the price to average earnings from the past ten years. Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year.

To calculate P/E10:

1. Look at the yearly earning of the S&P 500 for each of the past ten years.
2. Adjust these earnings for inflation, using the CPI (ie: quote each earnings figure in 2010 dollars)
3. Average these values (ie: add them up and divide by ten), giving us e10.
4. Then take the current Price of the S&P 500 and divide by e10.
Wildly Optimistic Forward Estimates

Most PE estimates bandied about only look reasonable based on inflated current earnings and wildly optimistic forward earning estimates.

I took a look at forward earnings estimates and the so called Fed-model in The Question "Are Stocks a Screaming Buy Relative to Bonds?" Creates False Premises Here are a few key snips....
Relative Valuation Comparisons are Problematic

The question "Are stocks cheap compared to bonds?" is pretty much like asking "Are rubber bands cheap compared to oranges?"

When both stocks and bonds are unattractive, assuming one has to choose between those classes is tantamount to asking "Would you rather risk losing an arm or a leg?"

The correct answer to that last question is "Why risk either?"

False Premise

Thus, right off the bat, the initial question implies a false premise "Should one be in stocks or Bonds?" Why does it have to be either?

Relative valuation comparisons can get one in all kinds of trouble. Both asset classes may be overvalued or undervalued.

Indeed, If stocks and bonds are richly priced, perhaps one should be in gold, commodities, currencies, cash, or hedged in some fashion. There is absolutely nothing wrong with sitting on the sidelines.

Forward Earnings Estimates Persistently Optimistic For 25 Years

A a McKinsey Quarterly report Equity analysts: Still too bullish
No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago that produced sobering results. Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.

click on chart to expand

Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year,4 compared with actual earnings growth of 6 percent. Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession. On average, analysts’ forecasts have been almost 100 percent too high.
Because forward estimates have been far too optimistic and also to eliminate huge earnings spikes, Robert Shiller and sites like multpl.com use 10-year smoothings.

Finally, I do not believe current earnings statements because banks are still hiding losses off the balance sheets, assets are still not marked-to-market, reserves are insufficient to handle upcoming losses, and because various capital-raising efforts required by Basel III have not been implemented.

On that basis, the market (and forward estimates) are both far frothier than the opening chart implies.

Mike "Mish" Shedlock
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