S&P 500 Earnings are Strong + Stock Values are Weak = Opportunity

Extensive research, experience and analysis spanning more than 40 years has taught me that earnings determine market price in the long run. I have dubbed this principle with the acronym EDMP. However, there also exists a short-run evil twin sister EDMP. This principle states that emotions determine market price in the short run. Currently, the evil twin sister EDMP is in charge. In the longer run, I believe this spells opportunity based on the oldest of all investing adages "buy low sell high."

Earnings Are Strong

Dirk Van Dijk, a Director of Research at Zacks Investment Research, recently published an article titled: Earnings Strong, Economy Not. The following excerpts tell the S&P 500 earnings story:

"The Earnings Picture

Second quarter earnings season is effectively over, with 497 or 99.4% of the S&P 500 reports in. With the exception of a handful of financials, most notably Bank of America (NYSE:BAC), which had a $12 billion negative swing in net income from last year, this is another great earnings season.

The year over year growth rate for the S&P 500 is 11.9%, way off the 17.1% pace those same 497 firms posted in the first quarter. However, it you exclude the Financial sector, growth is 19.4%, actually up slightly from the 19.1% pace of the first quarter. At the beginning of earnings season, growth of 9.7% was expected, 12.2% ex-Financials.

Attention will now start to shift to the expected growth in the third quarter. Things are expected to slow a bit, with 12.30% growth expected overall, and 11.9% if the financials are excluded. While that is down fairly significantly from the second quarter, especially ex-financials, it is right in line with what the expectations for the second quarter were before companies started to report.

Top-line results were also very strong, with 10.45% year over year growth for the 497, actually up from the 8.77% growth they posted in the first quarter. The top-line results are even more impressive if the Financials are excluded, rising to 10.71% from the 9.49% pace of the first quarter.

Top-line surprises have been almost as good as than the bottom-line surprises, with a median surprise of 1.76% and a 2.46 surprise ratio. The revenue growth in the first half is remarkable, given only 0.4% GDP growth in the first quarter and just 1.0% in the second, with low overall inflation. High commodity prices helped revenues among the Energy and Materials sectors, and higher growth abroad and currency translation effects from a weak dollar have also helped.

Looking ahead to the third quarter, year-over-year growth of 6.16% is expected for the full S&P 500, and 6.38% growth if Financials are excluded. At the very start of reporting season, revenue growth of 9.62% total growth was expected, and 8.94% excluding the Financials."

Stock Prices are Weak

The following F.A.S.T. Graphs™ covers the earnings and price relationship of the S&P 500 since calendar year 1992. All of the earnings numbers come directly from Standard & Poor's Corp. (Note that only every other year's data is typed on the graph due to space constraints, however, each year's data points are plotted on the graph). The orange line represents earnings multiplied by the S&P 500's 150-year historical normal PE ratio of 15. The blue line represents the S&P 500's last 20 year's normal PE ratio of 20. The black line represents monthly closing stock prices. The green shaded area graphs earnings, and the light blue shaded area shows dividends paid out of earnings.

There's an important lesson on statistical analysis that I believe this graph offers. Although it is statistically correct that the normal PE ratio for the S&P 500 over the last 20 years has been 20, the graph shows that this number is somewhat misleading. In truth, there have only been a few times over the last 20 years where the S&P 500 was valued precisely at 20 times earnings. Clearly, as the graph vividly illustrates, stock values have often been dramatically above 20 times earnings, and often dramatically below 20 times earnings over this time frame.

Consequently, I offer that this graph provides a much more relevant and comprehensive view of the S&P 500's relative valuation over the last 20 years than the statistic does. Of course, the same can be said of the 150-year historically normal PE ratio of 15. On the other hand, it's interesting to note from the graphic below that this is the only time in the last 20 years that the S&P 500 has been valued significantly below the normal 15 PE ratio. To me this indicates that the S&P 500 is currently on sale.

The following graph plots the S&P 500's price to sales ratio since calendar year 1992. The current price to sales is low relative to historical standards. Once again, to me this indicates attractive current valuation.

Conclusions

If the S&P 500 achieves the earnings goal of $98.57 as estimated by the above graphs, its year-end 2011 earnings justified fair value would be 1478.45, which is approximately 23% higher than it currently sits. To be clear, this is a mathematical calculation based on the current and near-term earnings power of the S&P 500 companies. Also, based on current earnings estimates, the earnings yield for the S&P 500 is 8.4%, which is approximately 4 times higher than the yield on the 10-year T-note. Therefore, this is not a forecast that it will get there, only a calculation indicating that it should. The following excerpt from Dirk Van Dijk's article cited above corroborates this view:

"In an environment where the 10 year T-note is yielding 1.99%, a PE of 14.5 x based on 2010 and 12.5 x based on 2011 earnings looks attractive. The PE based on 2012 earnings is 11.3 x. Those PEs are based on the Thursday close (9/02/2011), some are even lower after Friday's fall (and the likely decline on Tuesday given the weakness in Europe on Monday)."

With all the negative talk that we are consistently fed, the truth is, that corporate America is strong. The fundamentals underpinning most of our great companies warrant higher valuations than they are currently receiving. With interest rates at all-time lows, and therefore, the price of bonds at all-time highs, they are less competitive to stocks than normal. Consequently, I believe that equity valuations should be higher than normal, not lower. Therefore, I feel that now is a great time for investors to be building equity portfolios whether the market is at the total bottom or not.

Disclosure: No positions at the time of writing.