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I ran the following what-if study. Perhaps some folks here will find it of
interest.
The idea behind the study was to first look at the relationship between changes
in
stock prices and changes in earnings, and the second part of the study projects
the price of the S&P forward, and demonstrates how dramatically the price might
fall, even though earnings are improving at a normal pace, yet the P/E premium
recedes from its current high level down to a level more typical of bear market
and recessionary periods.
I began with the S&P earnings data (and forecasts) on this page:
http://www.spglobal.com/earnings.html
The first thing that I looked at was the relationship between as-reported
earnings changes (the earnings that including acquisition charges ans
amortization) and S&P price changes. See the attached chart, which shows the
quarterly percent changes for the S&P and S&P earnings, annualized.
Over the 1988 through June 2002 timeframe (14 years), the average annualized
S&P percent change was 11.4% with a 16% standard deviation. The average
annualized EPS change was 6.4% with a 28% standard deviation. The first simple
conclusion we can reach is that something like 5% of the excess return in the
S&P was due to "P/E inflation" over the 1988 through 2002 period.
Interestingly, when we eyeball the chart, it is difficult find a relationship
between S&P price changes and S&P earnings changes. In fact, a linear
regression of s&P price change as a function of EPS change gave an R-squared of
close to zero, confirming that S&P price changes appear unrelated to EPS
earnings changes during this period.
I also looked at the lead/lag relationship between S&P price changes and EPS
changes:
Lag Correlation
0 0.21
1 0.21
2 0.13
3 -0.03
4 -0.11
5 -0.23
6 -0.35
Above, "Lag" is the number of quarters that EPS is lagged in the correlation
calculation. The convential wisdom is that S&P price changes lead EPS price
changes by 2 to 3 quarters (6 to 9 months). The correlation study above shows
that 0 and 1 quarter EPS lags (or S&P leads) had the highest correlations, but
the level of correlation was rather low. Lags of greater than 2 quarters shown
an inverse relationship.
I then tried to forecast the S&P forward 3 years, by beginning with the
analysts
rather optimistic EPS forecasts for the next 5 quarters, and then assumed an
average annualized EPS gain of 6.4% annual growth rate after that (which is in
line with the average over the past 14 years). Some might argue that S&P
forecasts are unrealistic, and that the economic environment may not support an
EPS growth rate of 6.4% -- I'll simply argue that this scenario is at least
somewhat optimistic in the current economic climate. To complete the
forecast, I assumed that the trailing twelve month P/E of 28.2 drops over the
course of the next three years to a rather low level of 10.7 which was last
seen in 1988. Thus, the forecast assumes that earnings growth is robust and at
least as strong as that seen in the last decade, combined with a decline in
P/E. As an aside the recipricol of 6.2% would yield roughly a P/E of 15.6,
which is consistent with the longer term S&P average (as reported) P/E of
17/so. Thus, the P/E inflation of the past 1990's doesn't seem to be justified
by the actual EPS growth rates.
Given the forecast's assumptions, the S&P would decline further to about the
545 level in Q3 of 2005. In this scenario, given reasonable expectations for a
risk premium on the stock market, the S&P should be trading at about a 477
level in order to be a value-based buy at this time.
To summarize:
1) The connection between S&P price changes and EPS changes during the
1988-Q2.2002 time frame seems tenuous at best.
2) The P/E inflation seen during the 90's (and especially the late 90's) seems
unjustified, based upon actual EPS growth rates.
3) The combined assumptions of average to high EPS growth rates and a declining
P/E benchmark leads to the conclusion that the S&P can drop a lot further over
the course of the next three years.
4) For the S&P to trade higher from here, either the EPS growth rate will need
to be much higher than normal, or the market will have to remain comfortable
with historically high P/E levels.
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