Historical Data Disproves “Trough P/E Multiple on Trough Earnings” Myth

Doug Kass, a hedge fund manager dedicated to short selling and frequent guest on CNBC, made a call on the air Monday that the S&P 500 could make its lows for the year this week. A bold call indeed, given that Doug is a short seller and has been correctly bearish on the economy’s prospects for a long time. His reasoning is mostly based on extreme pessimism (not unlike in November when we made a short-term low) and low valuations.

Other commentators debate the valuation point. CNBC’s own Bob Pisani made the case that assigning a 7 or 8 P/E ratio (a typical number at bear market bottoms) to this year’s depressed earnings level forecast (currently around $50 for the S&P 500) is reasonable. Pisani concluded that unless you think that earnings in 2009 will be substantially above $50 (which is very unlikely), the market is not cheap because 7 or 8 times $50 is 350-400 on the S&P 500 index, versus today’s sub-700 level.

When Kass was on the air on Monday he rightly suggested that putting a trough P/E on trough earnings is not appropriate, but market commentators continue to insist that is where the market needs to go before a cyclical bottom can be put in.

I have argued against this logic on this blog before (sorry to keep harping on it), but I decided to dig up some evidence on this topic so perhaps we hear less of it in the future. Below you will find the earnings of the S&P 500 relative to the level of the index from 1970 through 1985, a time period that encompasses both the early 1970’s recession and the early 1980’s recession, both if which are similar in depth to what most believe will be our fate this time around.

From this data you can clearly see why everyone is using a trough P/E ratio of between 7 and 8 times earnings (the bear markets bottomed at a 7 P/E in 1974 and at 8 in 1981). The year of both market bottoms is in boldface to show these levels.

The key here is to look at the level of S&P 500 earnings during both 1974 and 1981. Although the stock market traded at the trough P/E ratios during those years, earnings were at record highs both times! The 1974 level of earnings ($9.35) had never been reached before. The same goes for 1981 earnings ($15.18). Therefore, the idea that we take trough earnings and apply trough P/E multiples is simply unfounded if we look at the very data people have supposedly been using.

Not surprisingly, I am far from the first person to point this out. John Hussman, former professor of economics and international finance at the University of Michigan, actually has created a more relevant P/E ratio called “price to peak earnings” which suggests that trough P/E ratios on previous peak levels of earnings are far more reliable bear market valuation tools.

Where would this type of P/E ratio peg the bottom of the current bear market? Well, S&P 500 earnings peaked at $87.72 back in 2006. Multiply that figure by 7.3 and 8.1 and you get a range for the bear market trough of between 640 and 710 on the S&P 500 index. Interestingly, especially given comments from Doug Kass predicting a possible yearly low this week, the index is in the 680’s currently, which is right in the middle of that projected range.

Hopefully actual data is enough to debunk seemingly popular myths about bear market low valuations for the stock market. While this evidence does not make it impossible for the S&P 500 to dip to 400-500, it would make such a move unprecedented in terms of the last four decades of market history, during which we have seen two recessions that are proving to be very similar to this one.