According to my calculations, the S&P 500’s mean P/E = 14.2 and median = 13.2. Thirteen companies were excluded due to negative earnings. The highest P/E was 90, and only ten firms had multiples greater than 30. The chart shows the frequency distribution of the individual firm’s P/Es constituting the index.
So is the market cheap? The low price multiples suggest that it is.
The Consensus estimates point to a strong recovery. According to Thompson, Analysts predict earnings to jump 15.3 percent this year.
In my opinion, that magnitude of growth is wildly optimistic. The Market isn’t buying it either. It’s not that the market is cheap, it’s that investors believe consensus estimates are too high. Why do I think that? Because if the market had full confidence in the forecasted numbers, I doubt the market would trade at these multiples. Hence, investors are pricing in lower earnings than the consensus forecasts thus making multiples higher.
The most probable outcome will be downward revisions to the earnings estimates. It’s possible that some of the consensus numbers are stale, meaning analysts have been slow to update them. This seems plausible given the current environment of uncertainty, and the inherent lack of visibility, may delay updates to estimates. In some cases, analysts may be waiting for a clearer picture going forward, or updated guidance from firms before making revisions to this and next years’ full year estimates.
Another possibly is that the required rate of return investors demand from equities rose, the “Equity Risk Premium.” This implies that the Market perceives increased risk inherent in the equity markets. This seems plausible since volatility has increased relative to years past. Higher perceived risk leads to higher demanded returns which compresses price-earnings multiples.
In my opinion, stocks are not as cheap as forward multiples suggest. Earnings estimates are too high and are likely to come down. In addition, the ERP has increased pinching multiples. However, if the economic slowdown begins to appear less severe as the Market is expecting, then stocks would be rather cheap. That would mean that analysts are not overestimating future earnings. However, given the turmoil in the housing market and the relationship to consumer spending, it’s likely the coming quarters will be weak.
Turley,
ReplyDeleteNice post you got here. Perhaps when earnings forecasts are revised downward sufficiently to reflect a new pessimistic reality, equities will bottom.
The market is fading the optimistic forecasts, when they become too pessimistic, equities will fade that too.
Arguing investors are demanding a higher rate of return? Dubious, investors always demand the highest rate of return possible on their investments. What they get is another matter altogether.
John,
ReplyDeleteAddressing the required rate of return- investors can choose assets and increase returns by assuming more risk. If they prefer a risk-free investment (excluding int rate risk) buy a 10 year treasury and receive 3.75%.
To achieve higher returns, invest in a risky assets such as stocks.
The market prices stocks so that the expected return, after adjustin g for risk equals all other assets.
So the opportunity cost is equal.
If risk is perceived to increase, then expected return must increase to compensate for the risk, thus stock prices fall.
I think I see what you are saying, Investors demand a higher rate of return, but once adjusting for risk its all equal.
Specifically I was referring to the CAPM - RiskFree + beta(equity risk premium) = K(e)
I was suggesting the ERP has increased.