Is it time to buy? Part 2

Valuations

One key factor in assessing whether it's time to buy - if not THE factor - is the market's valuation. But how do we determine that?

Let's start by figuring out the market's P/E ratio. Where do we get that information from?

One source is from the S&P 500's namesake, Standard and Poor's.
www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

From this worksheet, we can see that the S&P's 2009 earnings are forecast as:
-Operating earnings per share (bottom up): $97.32

Is that the best estimate to use? I honestly don't know - the news media make reference to Thomson Financial's IBES database, but it looks like that's a paid database. Please write to me if you know a better source!

Meanwhile, the S&P 500 closed at 850 on October 27, 2008. This implies a P/E of only 8.7 for 2009. The sounds like a screaming buy, given that the market normally trades at a P/E ratio of 15.

But, how solid is that earnings number? The asset management firm GMO has put together a timely analysis for our purposes at http://www.gmo.com/websitecontent/JGLetter_ALL_3Q08.pdf. Here the news is bleak: profit margins are still 20% above average, but typically fall to fall to 20% BELOW average during severe recessions.

That suggests a floor of $58 to the S&P 500's 2009 (or 2o10) earnings, earning the S&P 500 index a less-appealing valuation of 14.6.

Add to that the fact that P/E ratios typically drop below 10 during really bad bear markets. To be generous, let's use that 10x ratio (yes, it can go even lower, all the way down to 8 in the 1970's, but let's hope that doesn't happen again) and our trough earnings of $58. That would imply an S&P 500 index level of 580 - scary stuff. (And, not coincidentally, the bottom end of GMO's forecast range).

So what? Well, at "normalized" levels - earnings of $78 and a P/E of 15 - the market would be fairly valued at 1168. But these are not normal times, since bear markets often overshoot. I'm not going to give any financial advice here, but let's just say I'm comfortable buying with a P/E of 12 at earnings 70% of today's - with both P/E and earnings below long-term trend, I can be more confident in a solid long-term return. That, in turn, implies a price target of 817, so I'll start buying sometime soon.

And if you buy, too, good luck to us all!