Monday, June 2, 2014

Historically, A Decline In Earnings Caused P/Es to Spike Higher Than They Are Today

In a recent post, we looked at factors, including valuation, that will drive SPX returns over the next 12 months (post).

Since the late 1800s, SPX trailing 12 month (TTM) P/Es have been a median of 14.5x. In comparison, current "as reported" P/Es are 19x through 1Q14 (source).

19x is quite high. Between April 2005 and September 2007 - the heart of the prior bull market - P/Es never exceeded that level.

Yet, it's generally assumed that P/Es go higher than 19x (into the 20s) during bull markets. A look at the chart below seems to confirm this.

That assumption is false. Leaving aside the late 1990s tech bubble, nearly every instance where P/Es exceeded current levels was started by a fall in earnings. In other words, earnings declined before the market knew it, pushing P/Es higher.

Let's review the history:

1888-89: Earnings fell ~30% pushing P/Es to 20x. SPX eventually declined ~10%.

1894-96: Earnings fell ~50% pushing P/Es to 27x. SPX eventually declined ~25%.

1921-22: Earnings fell ~50% pushing P/Es to 25x. SPX eventually declined ~10%.

1929: An exception - earnings grew ~15% into a peak P/E of 20x. SPX eventually declined ~50%.

1933-34: Earnings fell ~25% pushing P/Es to 26x. SPX eventually declined ~50%.

1938-39: Earnings fell ~50% pushing P/Es to 21x. SPX eventually declined ~50%.

1946-47: Earnings fell ~15% pushing P/Es to 22x. SPX eventually declined ~30%.

1961-62: Earnings fell ~10% pushing P/Es to 23x. SPX eventually declined ~30%.

1963-65: An exception - P/Es were 18-19.0x (never higher) while earnings grew 10% per annum.

1970-71: Earnings fell ~10% pushing P/Es to 20x. SPX eventually declined ~10%.

1987: An exception - earnings grew ~5% into a peak P/E of 21x. SPX eventually declined ~30%.

1991-92: Earnings fell ~25% pushing P/Es to 26x. SPX flat.

The period after 1992 is of course dominated by the tech bubble. P/Es peaked at 34x in 2000 before earnings collapsed by ~50% between 2000 and 2002. This pushed P/Es even higher, reaching 46x in 2002.

As earnings grew again between 2002 and 2007, P/Es gradually came down to 17x, which is historically high.

In 2007-09, earnings fell ~90%, pushing P/Es over 100x.

In the 110 years prior to the 1990s, there were only two brief periods were P/Es were over 19x while earnings were growing: 1929 and 1987.

The mid-1960s were entirely different to every other point in history: P/Es were 18-19x for several years. The main reason is earnings were growing at 10% per annum. It was a rare instance where high P/Es were justified.