Quick question. As of February 2009, is S&P 500 PE ratio trending down or up? If you are like most investors, then you believe the S&P 500 PE ratio is trending down as the stock market plunges. After all, the P part of the ratio is dropping.

In this case, you would be wrong. It turns out that the denominator E or earnings in the PE ratio are falling faster. In fact, with 92% of all S&P 500 companies reporting, the earnings are a -$11.82 according to Standard & Poor’s. This means the S&P 500 PE ratio is rising reaching $29.19 for the quarter ending December 2008 as shown with the black line in the chart below.

It is interesting to note that the forecast for the S&P 500 Index PE ratio rises so much in 2009. This is driven by two factors. First, Standard & Poor’s forecasts $32.41 earnings for the index. This is the lowest since the early 1990’s when the S&P traded 400 to 600 range. Second, to calculate the PE ratio, Standard & Poor’s uses the most recent closing price for the index, which was 788.42 on February 18, 2009. By holding the P constant and lowering the E, you have to get a higher PE ratio.

As we have seen, PE ratios often rise sharply following a recession. Several quarters after the recession is over, the PE ratio then turns back down, reflecting the rise in earnings, with the price either remaining constant or continuing to fall.

Yale University Professor Robert J. Shiller, author of Irrational Exuberance: Second Edition uses a modified PE ratio that smoothes out the volatility in the ratio. The denominator of this modified ratio is average inflation-adjusted earnings over the trailing 10 years. Shiller calls this modified ratio "p/e10." Using this data the modified ratio “p/e10” produces a PE ratio of slightly over 15, which is very close to the median of 15.7. In December 2007, the beginning of the current recession, the “p/e 10” was 25.95. Since markets tend to cycle above and below the median, we should expect the “p/e 10” to fall further before turning back up.

Is the S&P 500 Going Lower

The U.S. has had three recessions since 1988 according to the National Bureau of Economic Research, the group that determines when the U.S. has had a recession. These recessions are depicted above in red. In the recession of 1990 – 1991, the PE ratio began to climb before the end of the recession. Following the end of the 2001 recession, the S&P 500 fell another 200 points before rebounding. So far in the recession of 12/2007 - ?, the S&P 500 has continued to fall.

Does this mean the market is going lower? Not necessarily. As shown in the chart below of the S&P 500 index, the index continued to retreat after the 2001 recession. On the other hand after the recession of 1990 – 1991, the S&P 500 rose slowly. Besides, we do not know when the current recession will end.

Looking at the earnings forecast from Standard & Poor’s we might be able to assess which way the S&P 500 will likely move. The table below uses the trailing four-quarter earnings from Standard & Poor’s. It then applies a PE ratio to derive the S&P 500 index. When looking at the table, keep in mind that the median PE ratio is 15.7. The PE ratio is mean reverting, so we should expect it to fall further, possibly to 10.

S&P 500 Index Projections

In the upcoming March 2009 quarter, the earnings forecast are $27.01. A PE ratio of 25 gives us a target price for the S&P 500 index of 675. On Friday, February 20, 2009, the S&P closed at 770.

The S&P trailing earnings falls throughout 2009, placing further downward pressure on the S&P 500 index. The falling earnings are due to the negative earnings for the fourth quarter 2008 and the low earnings forecast for all of 2009. With a PE ratio of 30, the S&P could fall to 404, far below the current level.

This examination of earnings and PE ratios is telling us to expect a lower S&P 500 index throughout 2009. How far it will go down depends on several factors. First, are the earnings forecast correct? Investors should monitor earnings expectations throughout the year, looking for any changes either up or down.

Second, evaluate your PE assumptions based on the outlook for the economy and the markets. If earnings are running above the forecast from Standard & Poor’s, then you should expect the PE ratio to rise eventually. On the other hand, if earnings expectations are falling, then you should expect the PE ratio fall further. In each case, any move in the PE ratio will tend to move more slowly.

Given the current view of the economy and the markets, I am expecting the PE ratio to remain high, above 30 and likely reaching 50, as earnings remain low. A PE of 50 in the fourth quarter of 2009 would mean the S&P 500 would trade at 673, 100 points lower than the current level. Along the way, we could see the S&P 500 fall to as low at 600, as the market adapts to lower earnings and muted prospects.

As investors, we should assume that the trend for the S&P 500 is still down. It will be important to monitor the performance of the S&P 500 companies earnings announcements during the next several quarters to see how they match up to the forecast.

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