There are many institutional S&P 500 forecasts in the media for 2009, generally ranging from 850 to 1100 with some outliers on each side, but seldom is the underlying detail provided. One of the more common methods of estimation involves normalization of earnings times a reasonable multiple based on history.

This article will attempt to back into some of the leading institutional projections using normalized earnings and historically experienced multiples.

Key Historical Index Price Levels:

The S&P stands now at 924. It had a low of 741 last November and 666 in March. The high in 2007 was approximately 1575. The low in 2002-2003 was approximately 770.

Institutional Estimates:

We cataloged a number of institutional forecasts in a recent article. The forecasts here come from that article plus a few newer ones. Estimate publication dates range from early May through now (issued within approximately a month).

Goldman this week stated an expectation of 950 to 1050 for 2009

Marc Faber predicts a possible run up to 1000 to 1050 by July with a near-term retracement that will not go below 800.

Meryl Witmer thinks the market is just about right now. Archie McAllaster thinks the market is cheap at its current level.

Alan Abelson, editor of Barron’s, thinks the valuation is too high, and like Fred Hickey believes a selloff is in the offing, because the fundamentals don’t support the price level.

Deutche Bank predicts 1060 by year-end, while JP Morgan Chase is close to that predicting 1100 for 2009.

Morgan Stanley sees not much value above 825 to 850.

Barclay’s (older estimate from April 17) predicted 757 for 2009 year-end.

HSBC forecasts 900 for year-end 2009

We recollect reading some noted analyst predicting 1200 to 1250, but can’t remember who. Let’s toss it is just to keep the range fairly wide.

Normalized Earnings.

Here is a table that presents S&P 500 “as reported” earnings (including 2009 projected “as reported” earnings from Standard and Poor’s) for 50 years (from 1960 through 2009), along with the year-end S&P 500 index price (current price shown for 2009).

Note: The earnings for 1988 – 2009 are definitely “as reported” and are obtained directly form S&P. The earnings from 1960 – 1987 are a best effort collection by Robert Schiller that may or may not be “as reported”, but probably are “as reported”. The older the data, the more likely to be “as reported”. Operating earnings are a more recent type of report used often to help managers ignore real losses that they don’t want to count. In theory, “non-operating” losses for individual companies are highly irregular and create noise in the data, and in theory operating earnings give a truer picture of going forward profitability of a company. However, in reality for an index there is a regular, low noise flow of “non-operating” losses that should be considered by index investors.

The earnings are normalized (averaged without inflation factor) for 4 years, 7 years and 10 years. The rationale for the periods is: 4 years as a presidential cycle, 10 years as a very long time, and 7 years as in between.

We end up with normalized earnings of $47 to $53 (2009 alone at about $29).

click images to enlarge

Historical P/E Ranges:

Based on the numbers in the table, we see an average P/E over the 50 years from 18.9 to 22.2 times “as reported” earnings for 4 to 10 year normalization, with a minimum ranging from 8.5 to 11.1, and a maximum ranging from 35.8 to 47.8.

We take the position that we are past the worst of the crisis for a while at least, and that we are far from being in a normal (average) situation. Therefore, it might be reasonable and justifiable to assign a multiple to the normalized earnings somewhere between the minimum and average values.

Without trying to split hairs over whether we are closer to bad or closer to average, if we simply use the mid-point between average and minimum multiples, we get 13.7 for the four-year normalization, 15.2 for the seven-year normalization and 16.6 for the ten-year normalization.

S&P Price Forecast With Normalization and Historical P/E:

The mechanical process we have just gone through yields predicted values of approximately 660 to 800 for the S&P as a “fair value” now.

A straight average valuation, which we feel is unjustified, would render fair value of 900 to 1075.

Normalization would tend to suggest that there is more downward logic than upward logic. Government spin on the economy, until today positive sentiment, plus nervous cash on the sidelines, may suggest more upside than downside.

In any event, we see roughly 590 to 880 as the most likely range into which the S&P 500 will move in the near future based on this method. That range is the 660 to 800 plus 10% overshoot on the high side and minus 10% overshoot on the low side.

Proxy SPY, with a 1/10th of index corresponding price range, would come out at about 59 to 88. The current price (June 15, 2009) is about 93.

Charting the Results:

This chart of the S&P 500 shows a plot of the index with two blue horizontal lines bounding the 660 to 800 “forecast”, and two red horizontal lines bounding a 10% error factor in each direction.

The result of this mechanical approach is similar to but more bearish than the forecast by Morgan Stanley and by Barclay’s, and much lower than the other institutional analysts cited above.

Do-Over With Operating Earnings:

If you do the same analysis, but using operating earnings, you get a more cherry result. That makes sense, because operating earnings don’t consider mistakes, errors in judgment, and unavoidable losses — all losses none-the-less. When you have 500 companies in an index, you can bet there will be some number, not always the same ones, who have non-operating losses each year.

Operating earnings have a 4-year to 10-year range from $60 to $66, while “as reported” earnings have a range of $47 to $53.

Note: Be careful when listening to and using earnings figures. You can get confused. We get confused when labeling and specification is absent or limited. Distinctions are important. Are they trailing or projected earnings? Are they “as reported” (all-in), or “operating” (selective loss exclusion)? Example of possible confusion in Barron’s this past weekend: In a panel discussion, Scott Black said, “Analysts expect it [S&P 500] to earn $54 this year. Strategists are using $43″ (he appeared to be talking about “as reported” earnings, but did not specify). Then Abbey Cohen said, “Goldman is forecasting S&P 500 earnings before provisions of $63 in 2009 and $71 in 2010″ (she did specify “before provisions”, meaning “operating” earnings).

The average multiples with “operating” earnings are lower, because the earnings are higher, but the index price is the same whether you use “as reported” or “operating” earnings.

Using the same logic (but ignoring “non-operating” losses), we see a range of fair value between about 860 and 960 (with 770 and 1060 as approximate boundaries with 10% overshoots on either side).

If investors follow “operating” earnings the market will go substantially higher than if they follow “as reported” earnings.

Cautionary Statement:

First, this is no more than one of many methods you might apply to attempt to gauge fair value. The real utility of valuation methods is to use several with different inputs to triangulate a figure. This is one of the methods. Consider several.

Because the markets are irrational short-term and rational long-term, wide variance from these estimates is entirely possible. Because so much is up in the air about US government intervention in the market process, the rules could be rewritten overnight which puts all forecasts into a cocked hat.

As an investor, you’ve got to try to read and lead the market, and chose when to play and when to stay; but you also have to protect and conserve assets when your play is wrong. We think protective stops on risk positions make sense in this uncertain financial environment.

Richard Shaw
QVM Group LLC

Disclosure: We own SPY in some managed accounts.

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