Stock Market Forecast 2014 Thought Experiment Revisited

By: PhilStockWorld

Courtesy of Doug Short: With 66% of Q4-13 earnings complete, here is the latest update of my ongoing “thought experiment” for forecasting the S&P 500 price based on earnings fundamentals.

The previous two months, I issued a warning due to forecasted earnings being lowered while the average monthly closes went above the forecasted earnings projections. This month, 2014 earnings have been significantly increased from previous forecasts. As a result, the warnings have disappeared. I’ve included a chart below that illustrates the change since April 2013.

The first chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor’s website as of January 31st, 2014. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort’s monthly valuation update for instructions on downloading the spreadsheet.

Here are the key assumptions in the calculations:

• The 10-year average of nominal TTM earnings is 64.12 as of June 2013, rising to 72.56 by the end of 2014, based on “as reported” earnings forecasts.
• The average nominal cyclical P/E10 is currently 18.21.
• The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
• Standard & Poor’s estimates of TTM earnings for Q4 2012 through Q4 2014 consist of the following:
  
• The months between the quarterly earnings estimates are linear interpolations.

The blue line represents Standard & Poor’s TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2014 year-end earnings of $119.70 and an average nominal P/E of 18.21, we would see the S&P 500 at 2180. At this level, the nominal P/E10 would be 30.26, and the index would be about 65% above a hypothetical price multiple of the extrapolated 10-year earnings average (1322).

The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.21 and the 10-year average earnings of 66.87 for December 2013. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth and earnings estimates from Standard & Poor’s.

The optimistic view (blue line) would put us around 1916 in the S&P 500 by the end of February, the assumptions being that the Standard & Poor’s earnings forecasts are correct the nominal P/E10 ratio is the multiple we see.

The pessimistic view (red line) is a reversion to the historic earnings and nominal P/E10 multiple.

But history shows us that, regardless of your preferred earnings divisor (nominal or real, TTM or the 10-year average TTM), the P/E ratio has never hovered around the average. The market swings above and below its long-term average valuation in erratic arcs that can last for many years. For a long-term perspective on valuation extremes, Four Market Valuation Indicators and the compelling research of Ed Easterling on the history of earnings per share.

For an example of the drastic change in earnings forecast from last month, take a peek at the following chart.

Typically, as the end of the quarter gets closer, earnings forecasts get pretty close as shown above by Sept 13 to Jan 14 Q4-13 earnings around $97.00 for 4 months. However, in the last 30 days, earnings have surpassed expectations as a very large jump occurred in expected Q4-13 (and thereafter) earnings.

Check back next month for a new progress report.

Note from dshort: For some interesting comparisons, here are Chris’s charts from the last several months, based on the then current Standard & Poor’s spreadsheets.

- Phil

www.philstockworld.com

Philip R. Davis is a founder of Phil's Stock World (www.philstockworld.com), a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders. Mr. Davis is a serial entrepreneur, having founded software company Accu-Title, a real estate title insurance software solution, and is also the President of the Delphi Consulting Corp., an M&A consulting firm that helps large and small companies obtain funding and close deals. He was also the founder of Accu-Search, a property data corporation that was sold to DataTrace in 2004 and Personality Plus, a precursor to eHarmony.com. Phil was a former editor of a UMass/Amherst humor magazine and it shows in his writing -- which is filled with colorful commentary along with very specific ideas on stock option purchases (Phil rarely holds actual stocks). Visit: Phil's Stock World (www.philstockworld.com)

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