Here is one super simplistic, maybe too simplistic, but certainly quick and dirty way to guess what might be a fair value of the S&P 500 index in the near future.

The following chart of 12-month trailing S&P 500 “as reported” earnings and year-end index prices provided by Standard and Poor’s shows that S&P projects $37.81 for 2010 “as reported” earnings for the index.

Looking back in history, we find that the last index price trough in the 2002-2003 period had “as reported” earnings that bracket the 2010 estimate.

The 2010 estimate is about mid-way between the 2002 and 2003 earnings, so it might be reasonable  to assume that the index level in 2010 might be mid-way between the 2002 and 2003 prices.  That would put the index in the high 900’s, near 1000, by year-end 2010.

The index is at about 924 on June 15, 2009.

There are earlier periods during the 1990’s that had earnings near $37 too, but they were in the midst of the dot.com boom which is an unrelated period of very high growth rate assumptions.

If you add one level of complexity based on the assumption of slower growth after 2010 versus after 2003, you might knock the valuation down a bit.

A 10% valuation haircut due to slower growth would put the index in the high 800’s, near 900, in 2010.

This angle on valuation is far from scientific, but is has some gut level kind of appeal.

If that’s reasonable, it doesn’t leave much room for gains from here.  The chart shows the 2003 and 2002 year-end prices from the table above (circled in red) and the possible price level derived with this super crude method (circled in blue).

click image to enlarge.

It’s tempting to discount this approach, because it offers no optimism and is seat of the pants only, but if earnings 18 months from now are 2/3 of what they were 18 months ago, and growth prospects are reduced, why wouldn’t a disappointingly low valuation be within the realm of reasonable probability?

The number one reason it might not be reasonable, is that the 2010 earnings estimate by S&P could be too low, but if it is not, then the index price prospects are not good.

The number two reason it might not be reasonable, is that earnings multiples may expand — low interest rates and all that.  Well, maybe, but the low rates are out of desperation, not normal cyclical pro-growth stimulation — and in our view the current federal administration’s policies are not pro-growth; and higher savings rates, higher tax rates, lower institutional leverage limits and tighter credit policies are not pro-growth.

We are very uncomfortable suggesting the possibility of such a dismal price future for the index, but we are not willing to totally disregard valuation perspectives, just because we don’t desire the outcome.

Richard Shaw
QVM Group LLC

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