S&P Market Forecast

I've been itching to provide my outlook for the markets for a few weeks now. I didn't get the time to be as robust as I wanted (yes, I'm still working on the rest of the credit crisis posts), but I did want to get something out there in advance of the markets taking shape in 2009.

This analysis is admittedly a bit "back of the envelope", but it's where my brain has taken me. This will look at a target for the S&P 500 - one of the most widely used stock indices. Earnings season, where public companies have to report their performance to the public and provide an outlook on the future, is beginning. This is where the action will begin in my opinion.

The table below shows the historical values of the S&P 500 Index, the collective earnings of the index (using operating earnings per share), and the implied price-to-earnings (P/E) ratio.

Data from Standard & Poors website - direct link here.

As you can see, the market has been on a wild ride up since 1988. Earnings for 2008 are still a forecast, but are currently expected to come in at 65.79 - a 20% decline from 2007. A collection of forecasts from companies in the S&P 500 places the current forecast for 2009 earnings at 81.80. I believe this is far too optimistic. Also, notice the historical P/E ratios. They peaked in the late 90's during the tech boom. When that bubble burst, earnings and P/E ratios collapsed. The implied P/E for 2008 is at its lowest since 1988 when the market was recovering from the 1987 collapse. The P/E ratio roughly indicates how much investors are willing to value future earnings (with appropriate assessment of risk and the value of money based on inflation).

This next table is self-created. It shows an implied revenue value for the S&P 500 based on various assumptions of their combined operating margin. I could not find reliable data on what this value actually should be, but I think a range of 10%-15% is reasonable. I also estimate a decrease in revenues which should be roughly commensurate with a decrease in GDP. I'm not optimistic that 2009 nominal GDP will grow over 2008. I've provided estimates for a 2% and 5% decrease. Recalculating the earnings based on no changes in cost (a pessimistic assumption) yields the below values.

I recognize that most of this is probably perceived as pessimistic at this point, but that's why I wanted to post this article now. I think the earnings season which is now underway will be filled with bad news and companies adjusting their forward outlook. Based on this, I'm projecting a range of 55-60 for S&P 500 earnings in 2009.

This last table then takes a range of earnings estimates along with P/E targets to calculate a target range for the S&P 500 Index. As you can see, my target range (in green) is wide: 550-720. These are not exact numbers, but they do reflect a range of possibilities. I think that as earnings reports and forecasts roll out, that P/E ratios will also drop on market uncertainty. The only thing holding that back at this point is the low yields on government debt which I do not believe will stay so low given the huge amount of new supply (i.e. the budget deficit) which will enter the market.

So, there you have it. We hit our most recent low on the S&P in November at around 750. I'm not sure when we'll hit the new bottom, but I don't think it will take long for us to drop below 750. It could be next week. If we don't drop below that level by Valentine's Day, then I would look towards Memorial Day to test that low. If we make it through Independence Day without dipping below 750 for a measurable period of time, then I will concede failure in my outlook. If we do stay below 750 for a few weeks anytime prior to that, then watch out! I think we'll be headed for about 600-640. This would imply the Dow Jones being around 6000 (typically, the Dow is about 10x the S&P).

(Disclaimer: I am not a financial advisor. Do not take this as professional advice. These are merely just my opinions.)