Valuations & Earnings

As I discussed last Thursday, we are witnessing a significant rerating of valuation multiples in the stock market. S&P’s downgrades accelerated the downward adjustment of P/Es that has been underway since April. The questions are how much lower can we go, and how soon can valuations reverse course? One more important question: Will earnings hold up despite the sharp drop in valuations? The risk, of course, is that the recent plunge in stock prices turns into a self-fulfilling prophecy by depressing confidence and economic activity. First, let’s review how much forward P/Es have declined since the final week of April through yesterday:

(1) The S&P 500’s P/E dropped from 13.2 to 10.4. That’s the lowest since March 6, 2009. At the end of 2008, it bottomed at 11.3.

(2) The S&P 400’s P/E dropped from 16.5 to 12.0. That’s the lowest since March 20, 2009. At the end of 2008, it bottomed at 11.0.

(3) The S&P 600’s P/E dropped from 17.3 to 12.7. That’s the lowest since March 13, 2009. At the end of 2008, it bottomed at 12.8.

Why is this happening now? As I discussed last Thursday, there has been a secular decline in the market’s forward P/E since the beginning of the previous decade. It seems to coincide with the decline of America’s geopolitical stature and the steady erosion of fiscal discipline in Washington.

The stock market crashed on Black Monday, October 19, 1987. The DJIA dropped 508 points to 1738.74 that day. That was a 22.6% collapse in just one day. The stock market recovered a few months after the 1987 crash as industry analysts continued to raise their 1988 earnings estimates for the S&P 500.

Apparently, industry analysts received and read my Don’t Panic Memo of yesterday. The S&P 500 forward earnings rose to a fresh record high on August 5 as they raised their 2012 estimate to a new high. I am certainly concerned about the possibility that the latest crash could depress the economy and earnings. However, I am inclined to believe that it won’t be a self-fulfilling prophecy: More like 1987 than 2008.