As mere mortals it is easy to get caught up in emotions and recent price action and become fearful. Arguably the best way to avoid investment mistakes is to set aside emotions and focus on facts. I’m not saying it’s easy to do. The S&P 500 is down about 8.8% so far this month. Technology stocks are down closer to 10%. Google and Amazon reported earnings yesterday and between missing targets and setting future expectations lower, the market took another leg down today.
Instead of reacting to recent swings with emotion, let’s take a look at understanding what is going on and then consider what a ‘fair price’ for the market should be given the economy.
What is Causing the Volatility?
The fact of the matter is that it is very difficult to pin market corrections on any one factor. Stress in the market builds up and at some point it gives way. It reminds me of the child’s toy called ‘The Last Straw’. You take turns adding straws to the camel’s back until it breaks. Recent articles have talked about rising rate, climbing dollar, aggressive Fed tightening, trade war fears and international risk such as emerging market currency risk and debt problems. Which of these has caused the problem? It is difficult to say with any certainty. So as the market was declining today I took a deep breath and ran some numbers. Crunching numbers is a very good way to counter balance emotions.
What is a Fair Price?
Let’s just run a few numbers and see how things look. We’ll use the S&P 500 companies. Earnings for 2018 are estimated to come in at $157.39 per share. Okay. So, that gives us a PE ratio of 2658.69/157.39 = 16.89. At current levels as of today, we are trading at PE below 17. This is well below where we have been trading the last 3 to 4 years. So is it possible that we are just looking at a healthy correction or are we on the cusp of some much larger drop?
Well, next year the analyst estimates for the SP 500 are $176.36. So this gives us a forward PE of just 15. I really like the sound of that. But to get there we would need to see growth of 12% in earnings. I discount analyst earning expectations because they always start too high and adjust down. Instead of using their number, what if we take the real GDP growth and add inflation. This is pretty conservative in that we don’t even account for share buybacks.
Today’s GDP number for Q3 came in at 3.5%. That is a very good number, although it’s down a bit from the 4.2% Q2 revised GDP. If we take an estimated inflation number of 2% then we have a simple estimate of earnings growth of 5.5%. So a more conservative estimate for earning next year would be $157.39 x 1.055 = $166.05. What is our forward PE multiple if next year earnings are 166.05? We get 2658.69 / $166.05 = 16.
Analysis
Yes it’s true that we may have hit peak earnings and earnings growth will now slow. Yes it’s true that tariffs may eat into earnings next year. Will they cut the earnings estimates by more than half? I think that is possible but not very likely. Is a forward PE of 16 reasonable? If interest rates don’t go well above 3.5% and inflation remains in check, this seems pretty attractive. What about tariffs? Yes, things could get much worse, but even if they grew substantially I don’t see how earnings come in lower than 3-4%.
Conclusion
If we listen to our emotions we wonder what the steep decline is telling us today. But without some sort of objective measure the gut reaction could be wrong. Running the numbers above show us that even with earnings growth cut in half from forecast the price for stocks looks pretty reasonable. Based on the strength of the economy and the most likely scenario for inflation and interest rates, along with a fairly conservative estimate for 2019 earnings, I think we can soften up the edges on these emotions.
source: Dow Jones S&P 500 earnings estimates 10-26-2018