Current Economic Conditions Explained Part IV: Valuation

In this fourth in a five part series, we are interpreting current economic data in order to provide you a rational, no-spin analysis of what is going on in the economy. In Part I, we looked at Economic Cycle Momentum; in Part II, Monetary Indicators; Part III, Sentiment. From that data, we concluded that we are nearing the trough in this economic cycle, the Federal Reserve Bank is in an unprecedented accommodative mode, and market sentiment is as low as it has been in decades.

All three of these categories point to a “buy” signal for the capital markets, but one important variable is left to consider. Is the market cheap?

Most people use the Price/Earnings ratio of the market to make that determination. Let’s take a look at it, and what it means.

The ratio of Price to Earnings measures the amount you pay for every dollar of earnings you buy. If the price of the market were $100, and its earnings were $10, the Price/Earnings multiple would be 100 divided by 10, or 10. That means that for every dollar the market earns, you are paying $10, or if everything happened just the same as it did last year, it would take you 10 years to get your money back.

Historical data show that the average Price/Earnings ratio (or “P/E”) of the Standard and Poor’s 500 Index (”S&P 500″) is 15.72. What is it now?

Not a simple calculation. Most economists will give you the current price and last year’s earnings. But that doesn’t make much sense, does it? You are buying future earnings, not past earnings. Last year the S&P 500 was 1478.49, and it earned $46.10 in 2008. That P/E was 1478.49/46.10, or 32 (twice its historic P/E of 15.72). Why would anyone have paid so much to invest?

The simple answer is that most 2008 S&P 500 earnings projections were nearer $80 than $46: Morgan Stanley predicted $78, Goldman Sachs predicted $78 and Citigroup predicted $77.5. So, the truly relevant question is what will the S&P 500 earn this year, and is its current price one that is relatively cheap to pay for those earnings?

Standard & Poor’s projects future operating earnings on its website in two ways; bottom up and top down. Bottom up analysis relies on company-by-company estimates of its earnings, and produces the higher of the two types of estimates ($82.27 for 2009). Top down analysis relies on a macroeconomic analysis which includes where US and global economies are in their economic cycles, and interpolates those projections to the capital markets. This methodology produces the lower of the two estimates ($57.97 for 2009).

Using the more conservative (top down) analysis, the market P/E is 872.8/57.97, the S&P 500 is trading at 15 – slightly under its historic price norm and cheaper than it has been in decades.
Another methodology worth considering is the “Fed model,” which is a comparison of the yield on the ten year Treasury note with the earnings yield on the S&P 500. The ten year Treasury note is currently 2.26%. The earnings yield, or inverse of the P/E, for the S&P 500 is 57.97/872.8, or 6.6%.

The comparison is this. A relatively risk-free yield, the 10 year US Treasury note is 2.26%. The earnings yield on the S&P 500 is 6.6%. While acknowledging higher short term volatility for the S&P 500, you are being paid almost 65% higher yield on the S&P 500 than the 10 year US Treasury note. Further, the price you are paying is less than its historic norm, a P/E ratio that has not been seen in decades.

From these data, we can conclude that the market is “cheap” on a relative basis.
In Part V, we will evaluate conclusions drawn from each of the previous four analyses, and allow you to make decisions that will assist you with your financial decision making.