Sunday, February 15, 2009

Earnings and valuation

The drop in earnings animates the discussions. See Barry Ritholz first with a very provocative target for the S&P500 and the response by Peridot Capitalist.
I created below a long term chart based on 10 year rolling earnings for the S&P500. The chart shows the PE, the average and a one standard deviation band. To discuss the findings further I added as well the YoY change in CPI.

Key findings:
(1) The 48 year average is roughly 22x 10 year rolling earnings.
(2) The current level of 15x is ca one standard deviation below the average. The last time it was so low was in the 70's.
(3) Indeed in the 70's this metrics was lower fluctuating between 15 and 10x. Note though that during that period inflation was much higher than currently.
(4) The market bottomed in 82 at 10x 10 year rolling earnings
(5) The Internet bubble is clearly visible. Interestingly the recent bull run from 2002 to 2007 happened at a valuation ca one standard deviation above the long term average.
(6) Interpretations of the apparently low level of valuation based on 10 year rolling earnings?
(a) Past 10 year earnings were inflated
(b) Future earnings will remain lower for longer
(c) The market is cheap

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