S&P Valuations: Normalized Earnings Framework

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S&P Valuations: Normalized Earnings Framework

One fundamental way to consider where the S&P 500 might bottom in the current volatile period is to look at other recent shocks and see where the index eventually troughed relative to:

  • Prior peak earnings power, highlighting recent best-case corporate cash flows.
  • Trough earnings, which anchors investor perceptions of worst-case operating margins that will provide the foundation for the next period of growth.

Here are 3 such events:

#1 and #2: Right after September 11th, 2001 and in the depths of the 2002 bear market.

At the S&P 500’s near-term trough after 9-11 at 966, it traded for:

  • 17.0x trailing peak operating earnings ($56.79/share for the 4 quarters ending September 30th, 2000).
  • 24.9x trough earnings ($38.85/share for the 4 quarters ending December 31st, 2001).

The S&P would only hit its 2000 – 2002 bear market trough in October 2002 (777 on the 9th), at which point it traded for:

  • 13.7x the 2000 peak for earnings mentioned above.
  • 17.6x then-current operating earnings ($44.04/share for the 4 quarters ending September 2002).

#3: On the lows at the end of the 2008 Financial Crisis, March 9th 2009, at a close of 677:

  • US large caps traded for 7.4x the prior peak for S&P operating earnings ($91.47/share for the 4 quarters ending June 30th, 2007…
  • … And 17.1x trough earnings for the post-Financial Crisis period ($39.61/share for the 4 quarters ending September 30th, 2009).

While there is a broad range of peak/trough valuations here, they average to 12.7x prior peak earnings and 19.9x trough earnings. That implies the following for S&P levels today:

  • 1,969, based on prior peak earnings of $155/share for the 4 quarters ending June 30th 2019.
  • 2,159, assuming markets will discount trough earnings of $109/share. That is 30% below the $155/share prior peak number, a reasonable expectation given current global economic disruption.

That averages to a trough S&P level of 2,064, which is 24% below Friday’s 4:00 pm print (and seems too pessimistic) but only 17% below Thursday’s close (and therefore feels realistic). And that’s the point of this analysis:

  • As chaotic as US equity markets are, there is a method to their madness. Investors are trying to find a level that discounts sustainable future earnings.
  • Normalized (aka sustainable) earnings expectations always live somewhere in between peak and trough, the math we’ve run through here.

As with our point in the “Markets” section of our full report, investors will be looking to Washington to support the US economy and make sure trough corporate earnings are not 30% below prior peak.