This article is a guest contribution from Doug Short, dshort.com.
Here's the latest update of my preferred market valuation method using the most recent Standard & Poor's "as reported" earnings and earnings estimates and the index monthly averages of daily closes for June 2010, which is 1083.36. The ratios in parentheses use the June monthly close of 1030.71. For the latest earnings, see the table below from Standard & Poor's.
– TTM P/E ratio = 17.0 (16.2)
– P/E10 ratio = 19.9 (18.9)
Background
A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.
TTM P/E Ratio
The "price" part of the P/E calculation is available in real time on TV and the Internet. The "earnings" part, however, is more difficult to find. The authoritative source is the Standard & Poor's website, where the latest numbers are posted on the earnings page. Free registration is now required to access the data. Once you've downloaded the spreadsheet, see the data in column D.
The table here shows the TTM earnings based on "as reported" earnings and a combination of "as reported" earnings and Standard & Poor's estimates for "as reported" earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.
The average P/E ratio since the 1870's has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as the 120s — in the Spring of 2009. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 33. It peaked around 47 two years after the market topped out.
As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. "Why the lag?" you may wonder. "How can the P/E be at a record high after the price has fallen so far?" The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.
Let's look at a chart to illustrate the irrelevance of the TTM P/E for a consistent indicator of market valuation.
The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 1-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected 10 years as the earnings denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.35. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.
Click here to see an overlay of the TTM P/E and the cyclical P/E10.
The Current P/E10
After dropping to 13.4 in March 2009, the P/E10 rebounded above 20. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren't especially relevant (e.g., the difference between the monthly average and monthly close P/E10).
Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.
