Idea of the Week – Caution: Below Normal US P/E’s ahead
Once upon a time, a “normal” P/E ratio for the S&P 500 was 15. The last couple of years have seen that figure hovering between 11 and 13, and the latest round of analyst revisions is producing some unsettling changes.
Released: July 25 2012
Length: 3 Minutes
The last five years has seen a decline in the average forward P/E ratio of the S&P 500. Watch this 3 minute video to see how StarMine Q2 Earnings Season Analysis shows lower future EPS values, which would push the P/E ratio higher—but for the wrong reasons.
What has happened to the “normal” price/earnings ratio for the Standard & Poor’s 500 index? That magic number used to be about 15 times forward 12-month earnings – but that was before the financial crisis changed this rule of thumb. Still, however, many strategists and portfolio managers like to refer to that particular level as “fair value”. Now, in the post-crisis era, has the ratio settled on its own new normal?
Since 1992, the forward P/E ratio for this bellwether index did average out at 15 – that’s the straight line that appears when we chart these figures for the last 20 years, using Datastream Professional Portfolio Analytics.
But around that trend line lie some big peaks and troughs. For instance, the decade from 1996 to 2006 was especially good for investors; during most of it, valuations were well above this “normal” level, at just over 16. The thanks for this above-average normal were propelled by the boom in the Internet, which, combined with the expansion of credit from 1992 to 2007, helped give investors the confidence to place a higher valuation on corporate earnings.
Then the world changed. Since the financial crisis began to rear its head in 2007, the average P/E for the S&P 500 fell to 13. The last two years have seen it hovering in a range around 11 and 13 times projected forward 12-month earnings.
What about the latest earnings data? So far, at least, S&P 500 companies appear to be reporting overall surprises in the form of better-than-expected second quarter results. But how are analysts viewing the third quarter? StarMine data shows us that analysts have been cutting their forecasts for profits for the period already underway. They aren’t confining their estimate revisions to those companies that have already reported results either, as companies yet to announce second-quarter profits have even lower estimate cuts.
That has some important implications for the forward P/E ratio. The smaller the “E” in that ratio becomes, the higher that figure climbs toward the upper end of the new normal range. That’s not good news, since valuations are rising for entirely the wrong reason: due to a contraction in forecast earnings rather than an increase in the prices investors are willing to pay for earnings.
Nor is the outlook encouraging; there are no catalysts on the horizon likely to encourage the earnings outlook, despite the fact that many investment managers like to claim that their investment theme includes companies with such a catalyst.
But let’s reflect on what averages really mean. After a decade during which P/E ratios hovered above “normal” levels, what is to say that this couldn’t be followed by a period of years during which P/Es would be below normal? It may look something like where we are now. So, it’s time to get accustomed to the new normal, or at least what is normal for today. And as you’re doing so, keep an eye on the StarMine earnings revisions for any sign that today’s normal might change – yet again.
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