The Right P/E For The S&P 500

As the market has continued to soar while corporate profits have continued to plummet, many market observers have noted that the P/E level of the S&P 500 has risen to such an extent that an overvalued market is now upon us. Indeed, Standard and Poor's reports a P/E for the S&P 500 of 122, which is clearly well above the index's historical range. Does this constitute a clear signal to value investors to stay away? Not on its own.

The problem with this measure of the market's valuation is that, at times, earnings may be temporarily depressed. During recessions, unanticipated drops in revenue occur which catch companies off-guard. Companies cut their costs in reaction to these revenue shocks, but there is a lag. To demonstrate this, consider the following chart depicting the profit margin level of the S&P 500 in the aggregate:

In every recession, profit margins temporarily shrink. Therefore, to justify what appears to be a ridiculously high P/E, we do not presume incredible growth in sales or returns on capital as was the norm in the late 90s. Instead, we consider what the earnings would look like when the write-downs and impairments are complete, and companies have returned to a more normal operating environment.

(As an aside, notice how strong profit margins were in particular during the expansion that preceeded this recession. This could be due to the growth that occurred in the financial industry, where margins tend to be higher as we saw here.)

Based on the above chart, the average historical profit margin for the S&P 500 appears to be around 5-6%. Using this number to determine the normalized earnings level of the index gives the S&P 500 a P/E of around 20. While this number is still a few points above the historical P/E for the index, notice how profit margins over the last business cycle have been higher than the historical norm. Investors expecting this trend to continue would estimate an even lower current P/E ratio using normalized earnings.

Though this method of calculating the market's P/E is preferred from the perspective of a long-term investor, this still does not suggest the market is cheap. Earnings are determined by multiplying profit margins with sales; with high unemployment and tighter lending standards, the sales level of the index (which is somewhat, but not completely, related to GDP) may shrink further from this level, reducing earnings further.

While the method described above can help estimate future earnings, determining the earnings level of the entire index with any degree of certainty is a difficult task indeed. It is much easier for the investor to focus on individual companies, and the performance of individual companies within the index will show high variability; many companies will be unable to handle the depressed earnings environment (due to debt or other fixed obligations) and will therefore fail. But companies with flexible cost structures will be able to return to profit margin levels commensurate with their histories, and investors should focus on identifying these companies in order to achieve returns that outperform the index.

* Source: Thanks to William Hester of Hussman Funds for the profit margin chart.