Now what do they mean? Both derive from Robert Shiller's work. As a quick aside, Yale allows you to view, learn and take tests from his economics course at their website. Now what the first chart shows is the price earnings ratio, that is the price of a stock certificate to the earnings generated for that same certificate. He did this for the entire market, so for my analysis now I just use the S&P500 to continue his analysis. By analyzing his chart it becomes plain that when the P/E is low good returns on average follow. As we all know from a previous post a statistic's professor can still drown in a river that is on average two inches deep. Therefore, Professor Shiller compiled an additional chart that shows further P/E deciles with the maximum return, minimum return, spread between those two points and average return. One can see the clear correlation again, my yellow arrow almost covers all the average return bars, that as P/E's rise the total return falls.
Perfect, so let's go out and invest and be billionaires. Well, we should check to see where we are at currently before we go put a lien on the house to buy S&P Index Futures. Here is the table I generated from S&P's really helpful website.
I took the expected earnings prognosticated from S&P's staff over the next 6 quarters and for the 7th quarter I used a terminal value. The discount rate is the BBB bond yield. I put out the entire equation but as the S&P represents the entire market Beta equals one, thus causing the Risk-free rates to cancel each other in the equation. Finally, a terminal value was established by using the average earnings from March 1988 to present and it is $9.45, then I applied again the same BBB discount rate and subtracted the trend growth rate of GDP at 3%. All these earnings were discounted back and summed to equal a net present value of $141.40, which sounds great. So utilizing Professor Shiller's method I created a table of Earnings and Multiples show here:
So that's great we reached a nadir in March of a sub-five P/E ratio and we are currently at just below 7, so we can expect via Shiller's chart a maximum return off 20%, a minimum of 3% and an average of around 13% over the next ten years. Dialing the home equity underwriter.
WAIT!!!!!
As with everything even though the analysis be true the pillars it stands atop may or may not be the most secure. Now it is true that corporations have done tons for their balance sheets over the past 20 months to secure earnings power. They have cut costs, inventory, staff, R&D, etc. So there is nothing left to cut, they have the bare minimum to continue conducting business. The estimates provided by S&P seem to think that we will just snap back into "normal" corporate earnings immediately. However, what about revenue growth, the top line from which the bottom line springs, doesn't that have to grow for these titans of industry to reach these estimates that analysts have laid out? Only 23 companies show an increase in revenue in this earning season. As I said above there is only so much cost cutting before you need top line growth to propel earnings. Just changing a few items such as GDP growth at 2%, which The Economist quoted in its latest offering, and dropping earnings to 3 and growing from there would put the index at a multiple over 18, which would indicate a max growth rate of 12% an average of 7% and a minimum of -2%. A sobering thought indeed.
As always when investing one should remember "Res tantum valet quantum vendi potest," or a thing is worth only what someone else will pay for it.
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