The chart above shows the S&P 500 from 2007 to now and compares it to six series calculated by multiplying the weekly forward earnings data for the S&P 500 by whole number multiples from 10 to 15. These series look like the vapor trails of six Blue Angel jets flying in formation. The S&P 500 has been flying within these vapor trails like a stunt plane. It’s a neat way to visualize how changes in the S&P 500 are driven by changes in forward earnings expectations versus changes in the forward P/E.
The chart confirms the obvious: Much of the short-term volatility in the stock market is attributable to the volatility in the P/E. Earnings expectations don’t bounce around very much from week to week. They tend to be inertial and autoregressive. In other words, they tend to move in the same direction they moved just recently. When they are rising, they tend to keep rising. When they are falling, they tend to keep falling.
Almost all of the recent plunge in the S&P 500 occurred between July 21 (1345) and August 8 (1119). Since then it’s been moving between the August 8 low and the September 1 closing high (1218). Yesterday, it tested the top of that range, but backed off a bit to close at 1207. The chart in our blog shows that the plunge from July 21 through August 8 was almost all attributable to a plunge in the forward P/E from 12.7 to 10.4. Forward earnings have edged down over the past five weeks. However, all of the recent volatility in the market has continued to be attributable to the volatility in the valuation multiple.
The chart below shows a similar analysis for the S&P 500 from 2000 through 2006. Back then, the S&P 500 peaked at 1527.46 on March 24, 2000 and fell to 776.76 on October 9, 2002. This bear market was mostly attributable to the sharp decline in the forward P/E from 25.4 to 14.2 from the peak to the trough of the S&P 500. Earnings actually held up surprisingly well back then. There was a particularly bad break in the P/E from 19 down to 15 during July 2002, as a result of WorldCom’s accounting scandal.
If recent history repeats itself, then the valuation multiple should recover partially again. It already has done so, from a low of 10.2 on October 3 to 11.2 yesterday. I’m not sure there is much more upside over the rest of the year, but there should be more upside next year.