Posted by The Fundamental Analyst on Mar 21st, 2009

There has been a lot of ink spilled about earnings and PE’s in recent months. As regular readers of this blog know, I have been harping on about earnings since late 2007. I have said consistently that analysts have been too optimistic in their forecasts. Analysts consistently fail to anticipate turning points in the earnings cycle, just as most economists fail to anticipate recessions. Take FY08 earnings expectations as an example.

Back in November 2007, analysts were full of optimism predicting FY08 S&P500 operating earnings of a record $105. 14 months later with 98% of S&P500 companies having reported 4Q08 earnings, FY08 operating earnings stand at less than half that November 2007 estimate at $49.50.

Now remember that operating earnings is before bad stuff, write-downs or one-offs as some companies like to call them although such terms are often just euphemisms for mistakes. As reported earnings or earnings including all the bad stuff were a dismal $15.10 in FY08. That’s the worse 12 month earnings performance since 1987. However if you use Robert Shiller’s inflation adjusted earnings, the 12 months ending in December 2008 was the worst year since 1948.

Turning to 2009, analysts have gotten more realistic but are still too optimistic currently expecting a little under $64for S&P500 operating earnings. Many in the market are expecting earnings of closer to $50, I think it could easily be closer to $40 with risks to the downside.

Clearly analysts are still playing catch up. Operating earnings were essentially $0 in 4Q08 however analysts have them rebounding to $13.31 in 1Q09 and $15.45 in 2Q09. Did things magically get better in 1Q09 for corporate America? Not from where from I’ve been sitting. That leads us to the question of PE’s.

Some market commentators take a trough earnings number for the S&P500, say $50, tack on a trough multiple of say 12x and come up with a figure for the S&P500 of 600. I consider that a very lazy way of estimating a market PE. It ignores the fact that trough multiples and trough earnings don’t go hand in hand. in the last recession, 12 month operating earnings troughed in December 2001 with the PE at just under 30x. In the early 1980’s, as reported earnings troughed in the first quarter of 1983 with a multiple of 12x, (inflation adjusted) however the trough multiple of about 7x occurred 12 months earlier.

So trough multiples don’t necessarily coincide with trough earnings. Plenty of analysts will be able to give well reasoned sounding explanations of the multiple they use, but at the end of the day they are no better than a guess. Despite a collapse in earnings in late 2008 the 12 month trailing operating earnings for the S&P500 was still slightly over 18.

As for reported earnings, thanks to an unprecedented disaster in 4Q08 that saw earnings of -$23 and change, the 12 month trailing PE closed the year at close to 50x. To make matters worse, the forecast PE based on reported earnings balloons to an unheard of 220x in the forecast 12 months to September 2008 based on an S&P500 of 725, the average level so far in March.

None of this is particularly useful in judging where we are in a historical sense. That’s why recently some are reverting to Robert Shiller’s 10 year average trailing earnings multiple. By taking an average earnings number over 10 years, wild fluctuations in earnings such as 4Q08 are smoothed out. Shiller calculates all his numbers after adjusting for inflation which is the most accurate way to do it. However I have reproduced Shiller’s method using the unadjusted numbers.

The PE of the market tells us what investors are willing to pay for stocks at certain points in time. Thus, because we are not interested in the actual number but the relative level over time, so long as the method is consistent, using unadjusted numbers serves the same purpose.

As it turns out the inflation adjusted and unadjusted numbers are very closely correlated. Shiller’s numbers go back to 1871 and thus the 10 year average earnings start at 1881. He uses as reported earnings and the average S&P level of each month. Over that approximately 130 year time frame, Shiller has an average inflation adjusted PE of 16.3x whereas not adjusted for inflation it is closer to 17.7x.

Using the unadjusted 10 year average as reported earnings PE to the end of 2008 gives a PE of 16.7x only slightly below the long term average. That falls to about 13.5x based on analysts forecasts out to 2010 and an S&P500 level of 725. That is if you believe analysts forecasts, which of course you shouldn’t.

In the great Depression the 10 year average PE got below 5x. in the worst post WWII recession of the early 1980’s they it got to about 9x and the recession of the mid 1970’s about 11x (all on an unadjusted basis). Since the current recession is set to eclipse the early 1980’s as the worst since WWII, should we assign a PE somewhere between the great depression multiple and the early 1980’s?

No, that would be no more rigorous than the trough earnings, trough multiple forecasts. All we can really say based on the historical record, is that investors are still willing to pay close to an historically average multiple for stocks whereas in other severe economic downturns they were not willing to pay even close to such multiples.

The above analysis suggests that the balance of risks to the PE multiple is skewed to the downside. The only way the PE multiple can contract further is if earnings expectations turn out to be too pessimistic (highly doubtful) or the S&P500 moves significantly lower. I know which outcome I think is more likely, how about you?