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The Devil’s Rally?

By Mike Minter, CFP^®

Earnings

Since most people feel earnings drive the market, let’s forget everything else for now and just focus on earnings and how they relate to prices. For us to do this, let’s pretend we are going to buy a business priced at $150,000. How much would we like this business to earn for us to be comfortable buying the company?

Well, after doing some research and finding that other businesses in the same industry typically sell for around 15 times their earnings, we would want this company to consistently make roughly $10,000 each year ($150,000/$10,000 = 15). Realistically, you might pay less since the earnings are not growing, but for simplicity, you get my point.

Now, let’s pretend we are going to buy the entire stock market or S&P 500 which is roughly the 500 largest publicly traded companies in the US. To make the numbers simple, let’s say it would cost us $1,000 and imagine that is a lot of money. First, you need to determine whether it is a good investment so you research how much in earnings the S&P 500 is generating. Before you see the actual numbers, you notice that over the last 80 years the average price of the S&P 500 is approximately 15 times its earnings.

Historical Averages

You also notice a couple other things. First, that over this 80 year time period, the S&P 500 traded in a range between 10 times earnings and 20 times earnings most of the time. Second, when you bought the S&P 500 at 10 times earnings, you typically did much better on your investment than when you bought it at 20 times.

Knowing this information, you might conclude the following on the S&P 500 priced at $1,000:

• If it is selling at 15 times earnings, it is fairly priced. Earnings would need to be in the $65 range ($1,000/$65 = 15.38).
  
  
• If it is selling at 10 times earnings, it is cheap. Earnings would need to be in the $100 range ($1,000/$100 = 10).
  
  
• If it is selling at 20 times earnings, it is expensive. Earnings would need to be in the $50 range ($1,000/$50 = 20).

Current Numbers

Well, actually the S&P 500 is priced on a smaller scale and is currently around $1,150 (as of 1/19/2010). So let’s look at the earnings for 2009. Since the 4th quarter numbers are starting to be reported now, let’s assume that they come in better than expected and 2009 earnings finish at $50 for the year. With the price of the S&P 500 at 1,150, the stock market would be selling at 23 times earnings ($1,150/$50 = 23). Based on earnings alone, the earnings would have to grow to over $75 before you got to fairly valued ($1150/$75 = 15.33). That is a 50% increase from where we are now. You probably wouldn’t buy the S&P 500 with that information but maybe earnings are supposed to increase significantly in 2010. So you look and find that the current earnings estimates for the S&P 500 in 2010 are $58.71. Not exactly a bargain at just under 20 times earnings and that is assuming earnings increase from 2009 by over 17%.

The last time we were in the 1,150 range on the S&P 500 was back in 2004 when earnings for the year were $58.55. Keep in mind, 2004 was not a year when the government, especially the Fed, was throwing money everywhere like they did in 2009. So maybe it answers the question of how the stock market can go up roughly 70% from the lows while unemployment, foreclosures and bankruptcies are at levels we have not seen in a long time and earnings are still well below fair value. Not only that, but our consumer, who is 70% of the economy, is currently in much worse shape as they deleverage or cut back spending since the good old days of 2004 when many had the luxury of spending the appreciation or equity they once had in their home .

Good News / Bad News

The good news for those who have a lot of money in stocks is over the short term, which potentially can last a couple years, anything can happen and using earnings as your only market indicator is not a good idea (especially if the government continues to spend).

On the other hand, history shows the stock market eventually returns to the mean. Since this is the case, I would not feel too confident at this point that stock market returns will be as robust as they have been the past couple of quarters. Just because we recently ended a decade of negative returns for the stock market, doesn’t guarantee this decade will start any better.

FYI - I am using (Generally Accepted Accounting Principles) GAAP reported earnings numbers. Considering all publicly traded companies are required to report these numbers and they have been around for the longest period of time, I hope most of you would agree that these are the numbers that make the most sense to use. You can use operating earnings or other numbers that Wall Street creates to justify buying at these levels, but considering their track record, I’ll leave that up to you.

Bottom Line…

I’m not superstitious but watching what is happening and thinking back to the March 2009 low when the S&P 500 hit 666, it makes you wonder if the devil is messing with us.

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