SeekingAlpha S&P 500 20 Year Earnings-Price Correlation

Our research suggests that there are two principle drivers of long-term returns that apply equally to individual stocks and indices like the S&P 500. The first is earnings growth, or more precisely the rate of change of earnings growth. Our research on more than 13,000 companies validates a strong correlation and functional relationship between earnings and price. Consider that earnings create the future income streams that are being discounted back to the present value. The second principle is valuation. Overvaluation leads to returns that will be less than earnings growth, fair value will drive returns equating to the rate of earnings growth and undervaluation will lead to returns in excess of earnings growth. Therefore, valuation and earnings growth can be used to explain historical returns and more importantly as reliable predictors of the future.

I will use our Great Companies, Inc. fundamental research tool to illustrate why we believe future S&P 500 returns should be significantly above average and achieved at less than recent levels of risk. The thesis for our bold forecast is founded on historically normal valuation metrics for the S&P 500 coupled with a general common sensed based forecast. Spanning more than 80 years, the historical normal PE ratio for the S&P 500 has been approximately 15. Using our Graham Dodd adjusted earnings correlated graph the more modern S&P 500 PE ratio over the past 20 years has been 17.4. As depicted in Figure 1, the price of the S&P 500 has closely correlated to its 4.4% earnings growth (green line with white triangles) at the modern 17.4 PE ratio, except for the period 1997-2003. This anomalously overvalued 6-year period clearly explains the poor returns this index subsequently produced, especially since its peak valuation in calendar year 2000. This is why I contend that measuring performance without simultaneously measuring valuation is a job half done.

Category:

Education

Tags:

• S&P
• 500
• Earnings
• Growth