Market Update: The S&P 500's P/E Ratio, Past and Future Happy Tax Day! Don't forget your IRS paperwork has to be postmarked by today. I suspect most of you have already taken care of your tax filing though, so you'll be able to turn your attention to other things.... like figuring out the market's true value.  As the subject line indicated, I want to look at the broad market's 'worth' by reviewing the S&P 500's historical and projected price/earnings ratios.  My analysis has a twist though... I'm not trying to prove anything bullish or bearish . I'm just trying to let the historical results speak for themselves so I can make an informed decision about how to proceed over the course of 2009. (It seems like most everyone one who does this same study is fishing for support of their predetermined opinion, which is very bad science.)    And So It Begins Well, for better or worse, earnings season is fully upon us. The results of the first quarter of 2009 could be a make-or-break affair, with the stimulus in full swing for the bulk of those three months.  The question isn't one of comparisons though, since we already know earnings won't even be able to compete with comparables from even just a year ago. The question we're trying to answer is strictly one of valuation - are stocks cheap or expensive now, and are they expected to get cheaper or more expensive in 2009? The nearby chart illustrates the S&P 500's aggregate P/E ratio as of the end of 2008, (since we don't have most of 2009's Q1 data yet). Of greatest interest is the thick blue line, which is a four-quarter average P/E. If you squint just right, the thin red line is the annualized quarterly P/E. The green horizontal line is resting at the 20.0 level. Two things stuck out to me about this chart and the one you'll see below.  First, the end of 2008 wasn't a complete disaster despite a non-existent P/E. The economy was supposed to be going to hell in a hand basket, but some companies managed to make some money. The S&P 500's operating loss was -$0.09, and its reported (actual) loss was -$23.25. It hurts, but it's not earth-shattering considering things are already on the mend.  [And before you get too excited about the apparently low P/E, bear in mind that a negative 'E' like we saw in Q4 can skew the reading lower. It will take about four quarters to wash it out. However, removing that negative quarter from the equation still leaves the P/E above 20.0 for well over the last year.]  What was the second curiosity? A little legwork first... To really add some perspective to this whole mess, take a look at the other nearby chart, which plots the same P/E ratio for the S&P 500, but this time I've added the projected P/E's (based on Standard & Poor's forecast) through 2010. Of course, the projected P/E's assume the S&P 500 will remain at its current price, even though we know it won't - we're just trying to get a feel for where it stands now in relation to its future. See anything interesting?  If the good folks at Standard & Poor's are right, then Q1 was the bottom from a fundamental perspective even if it wasn't the technical bottom. And, even if the analysts at Standard & Poor's are errantly optimistic, it's still not likely to get much worse than Q4's loss for the average stock. So yeah, stocks are compelling from that one perspective. Keep reading though. The key point I want to make is that the current earnings season is crucial - and I mean crucial - in determining whether or not the loss trends are behind us. We don't even have to see a huge degree of profits to shake it off.... just some profits  Standard and Poor's expectation for the S&P 500 during Q1 is operating earnings around $12.86, which isn't a lot. The expected 'reported' earnings of $7.32 is even less. That would translate into annualized P/E's of about 16.3 and 28.7, respectively.  Is that ok? It's not great, but I could tolerate any earnings that put the index P/E under 30.0... which is fortunate, since that's pretty much what Standard & Poor's is expecting through end of 2010. Go back and look at the second chart again to see what I mean. The projected P/E flattens right around 30 through 2010.  A lot of investors aren't going to be happy with that figure though, which means one thing and only one thing needs to happen to get these investors excited - the people at Standard and Poor's need to be wrong about how slow growth is going to be over the next two years. Frankly I hope they're wrong too, but I'm not counting on it.   Projections Aren't Set in Stone There's in inherent flaw in this kind of modeling I'm very surprised we don't hear more about - what if the projections are completely wrong? What if the S&P 500's earnings don't even move back up above $60 by 2010? What if they move to less than $10 by that time? Those are great questions, and I have the same concerns. Anything is possible, after all.  On that note I have to give credit where it's due. Though Standard and Poor's projections are always being adjusted, those guys actually do a pretty good job. I seem to recall they were a little behind the eight ball in 2003, but I doubt they'll make that mistake again. Moreover, S&P's analysts seem to have a better handle on economic cycles than their competition does. In other words, I don't think they're out of line to expect mild growth.  But what about the "this time it's different for the economy?" arguments? You know - what about deleveraging, and real estate woes, and unemployment? Yep, all those things are issues. There are issues and challenges to all recoveries though. Eventually the market finds a way. That's the cyclical nature of the economy Standard & Poor's analysts 'get' that most other analysts don't embrace.... the economy's cyclical ebb and flow is the norm. Too many forecasters assume the status quo is permanent.  Case in point - very few people believed 2003 would be a recovery year either, yet it was. Stocks were painfully expensive then too, with a peak operating P/E of 31.2 and a peak reported P/E of 46.5. Like I said, the market finds a way.   What Do You Do? As for your call to arms, here's what I'm suggesting. There are many, many stocks that have already come out of the recession and are doing quite well, so ignoring all stocks until the S&P 500's P/E falls under 20 is a mistake.... it will take too long for that to happen at our current pace. Plus, panic selling isn't likely to wipe-out all stocks in 2009 the way we saw it happen in 2008, so don't feel like you have to sit on the sidelines until 2011. Go ahead and find the highest-growth and best-value names, and watch those charts. On the flip side, if the Standard & Poor's projections are right then it's obviously hard to say stocks are 'cheap' at this point.  There's the rub... things are getting better, but it doesn't really matter yet. The overall market's aggregate P/E's are slated to stay in the mid to upper 20's through 2010.  In turn, indexing and "just buying good companies" are less than attractive themes right now. This may needlessly steer some investors out of the market altogether, so I'll counter by saying we're once again in a true stock-picker's market, even if we're not in buy-and-blindly-hold market yet.  In the meantime this earnings season could make or break any marketwide recovery effort for the foreseeable future (i.e. one quarter). It's still ultimately too soon to call, but we now at least know what to look for - any degree of profitability would be an improvement. That's it. The bar is actually set pretty low even if a recovery solidifies at a snail's pace.... which so far seems to be the case. I'll let you know how we're progressing as earnings announcements flow in, and I'll update the charts when I can.