Chart of the Day: Comical SPX Earnings Expectations

By RiskReversal.com  FEB 11, 2013 2:00 PM

It's important to consider the P/E multiple when trying to predict earnings results.

 


What if I had a crystal ball, and told you, "S&P 500 (INDEXSP:.INX) earnings results are going to be exactly unchanged from their current level over the next 18 months."

Where do you think the S&P 500 would trade in 18 months?

It all depends on the P/E multiple. That’s the crucial metric that no amount of research can determine. Finding the appropriate market multiple is like the key to the treasure chest, but no one really knows what the appropriate multiple should be. The importance of the multiple applies as much to single stocks as to the broader market. The P/E multiple for the S&P 500 has historically ranged between 5 and 40, so fortunately, there’s some historical basis. Unfortunately, that historical range would yield a S&P 500 level anywhere between 500 and 4000 based on current earnings. Not helpful, to say the least.

Over the last 18 months, S&P 500 earnings have been essentially flat. But the S&P 500 is up 40% from its October 2011 lows. It’s all about the multiple.

Alhambra Investment Partners posted a good chart (which I found via Tom Brakke, by way of Abnormal Returns) this weekend, illustrating the conundrum of the current market:


 
Forgetting the projections for a moment, what I first noticed was that earnings have been flat since June 2011. That’s what led to my thought exercise above, as the SPX is up substantially in that period, and I imagine most traders would say off the top of their heads that strong earnings growth has been one of the catalysts. Instead, it’s been pure multiple expansion.

But what about the 2013 projections? If accurate, then SPX earnings for 2013 will be around $110, and that does offer a bit of evidence that the recent rally has just anticipated this improvement. Yet it’s more likely that analysts just haven’t gotten around to updating their estimates for 2013. Given that 78% of SPX components have guided down so far this earnings season relative to consensus expectations, according to Goldman (hat tip: John Melloy), those analyst updates are going to be relatively severe.

However, none of this means that the market can’t keep going higher. Again, the multiple could keep expanding. But this is a rally driven by psychology more than anything else, which makes it more vulnerable, too.

This item by Enis Taner was originally published on RiskReversal.com.

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