How Expensive are “Normal” Earnings of the S&P 500

One fact makes this question very difficult to answer. It is that energy and financials accounted for such a high share of peak earnings. In fact, if we remove those two sectors, which accounted for 40% of the peak earnings reached in mid-2007, then we see there really was no bubble in the earnings of the other sectors during the last economic expansion. We can see a mild cyclical expansion relative to GDP from 2003 to 2007, but certainly nothing remarkable.

But how in the world do we normalize either energy or financial earnings? I think it’s useless to even try.

It occurred to me, however that removing these two sectors from both the S&P earnings and the S&P price, would give us some idea of how expensive or cheap the rest of a “market portfolio” might be.

That’s what I’ve done below. Thus, at the peak of the market in October 2007, the P/E of the market minus energy and financials was a hefty 24.6. Today the P/E on peak earnings is a more reasonable 13.1.

But how to normalize the earnings of the non-financial and non-energy part of the market? Well, because these earnings rose as a share of GDP by only about 20% during the expansion, I arbitrarily reduced them by 20% from the peak. Not enough you say? Before you jump on my numbers, consider that given today’s mix of market values, this “remainder portfolio” is 35% in information technology, 14% in health care, and 12% in consumer staples. All told, it’s about 76% in less cyclical and/or higher growth parts of the market.

I admit I would prefer it lower and closer to a 14 multiple that I could call cheap, but even if it were to go there, my downside is only about 15%.

Taking a Stab at Normalized earnings and Their Valuation

Past peak S&P 500 earnings……………………………………………$83
Portion of peak egs. attributable to financials and energy…….40%
Non-Financial and energy peak earnings…..……………………… $49.80
Peak price of S&P 500……………………………………………….. 1550
Financials & energy as % of peak S&P price…………………..31%
S&P peak minus financials and energy.…………………………. 1225
Non-financial & energy peak P/E (1550/$49.80)………….. 24.6

Current S&P 500 price……………………………………………………880
Financials and energy as % of current S&P price……….. 26%
Current non-financial & energy S&P price………………………..651
Non-Financial and energy normal earning power(peak less 20%)………………………………………………………………$39.85
Current P/E on normalized earnings……….…………………………….16.3
P/E on past peak earnings………..………………………………………….13.1

You might judge 16.3 x earnings as not being particularly cheap, but remember that the non-energy, non-financial “portfolio” we’re looking at is 76% invested as follows:

Consumer staples……………..16.3%
Health care……………………… 14.0
Information Tech………………35.0
Utilities……………………………. 5.5
Telecom……………………………. 4.9
Total % of portfolio 75.7%

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5 Responses to How Expensive are “Normal” Earnings of the S&P 500

  1. YVRb says:

    What’s the difference between “current non-financial & energy price/peak earnings” (at 13.9), and “P/E on past peak earnings” (which is 13.1=651/$49.80)?

  2. Paul F. Miller, Jr. says:

    No difference…it was a craeless mistake. Still getting used to using WordPress….thanks, Craig…have removed the latter number

  3. JE says:

    Paul,

    An interesting way to look at valuations.

    Thanks for sharing.

    JE

  4. Al-Hamour says:

    Paul,

    Like the breakdown of the earnings to discount the financial and energy stocks. However, how do you determine that 16 – 14 PE is cheap? I believe historically 12 PE is the average and during the 70’s actual trailing PE was 8-10x. What are your thoughts? I can’t seem to get data that goes back that far to determine what PE is warranted during recessionary times.

  5. Paul F. Miller, Jr. says:

    Well…first, P/E’s should rise during recessions because investors realize earnings are below “normal”. But I did not say that 16x was cheap…I said, however, that 14 would be. Considering the makeup of the non-energy, non-financial portfolio….heavily in technology, healthcare and consumer staples, all higher P/E groups, and considering that earnings in these groups are also below normal, even if only a bit, I would still maintain 14 is cheap. Although you are correct …in non-recessionary times, with earnings for the entire market a bit higher than normal, it would take a P/E of 12 or below to be cheap. Thanks for the comment………Paul

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