The P/E ratios of the 2004–07 stock market rally remained close to levels seen in the late 1960s, when interest rates were also relatively low. Instead, strong corporate earnings drove the market's growth.
According to a report titled “ Preparing for a Slump in Earnings ” from McKinsey, between 2004 and 2007, the earnings of S&P 500 companies as a proportion of GDP expanded to around 6 percent, compared with a long-run average of around 3 percent, with the highest increase in the financial and energy sectors.
This growth in earnings was primarily driven by increased sales. According to McKinsey, expansion of margins was not a significant contributor to overall earnings growth. These revenues were fueled by the expansion of consumer credit. This is the same credit that is currently causing the collapse of the credit markets.
Since the U.S, is experiencing a recession and we are in a bear market, investors are very interested in where earnings and P/E ratios are likely to go.
The financial sector has led with lower earnings expectations as these firms come to grips with the excesses of the credit markets over the last several years. This sector comprises about 17% of the S&P 500, so it can have a significant influence on the performance of the market.
To get another perspective let's take a look at data from Standard & Poor's. They maintain a database of S&P 500 quarterly Earnings and P/E Ratio that goes back till 1988 and includes projections for the rest of 2008. You can access it here . The chart below is from that Standard & Poor's data. To derive the P/E ratio the price of the S&P 500 is held constant as of the close on March 31, 2008 at 1322.70. The S&P 500 is trading below 1300 as of this writing.
From this source, it shows that Standard & Poor's expects a brief earnings dip in the fourth quarter of 2007 with the earnings trend returning to the prior growth pattern by the second quarter of 2008. Remember that much of the growth in earnings was driven by the growth in revenues which was fueled by the rapid expansion of credit that is now contracting significantly. The problem is this earnings forecast doesn't seem very logical nor does it follow history.
According to McKinsey & Company, the strategic consulting firm, in order for overall S&P 500 earnings to reach the long-run average proportion of GDP, profits would have to fall 20 percent from their 2007 levels. This excludes the financial and energy sectors, so we get a better focus on the underlying economy. Moreover, earnings would have to drop up to 40 percent to reach the lower levels in previous economic cycles.
The chart below adjusts the S&P earnings estimates to reflect the mid point of McKinsey's analysis. A 30% drop in earnings and then a more normal recovery over the next 3 quarters of 2008.
In the chart below the P/E ratio expands during the earnings decline and bear market, since the price of the S&P 500 was held constant. More likely the P/E ratio would either remain the same or fall. In either case the price of the S&P 500 would fall. For example, if the P/E ratio remained at 16, above the average of 14, and the earnings for 2008 reflected the forecast ($61.90 for the year) in the chart the S&P 500 would be 990.
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