Tuesday, September 9, 2008

P/E Scenario Modeling

For the past several months, the S&P 500 has been locked in a trading range of roughly 1230 to 1300. Why has it settled into this particular range? Allow me to offer a few reasons via a P/E scenario forecast.

In last Thursday’s blog entry titled “The Looming Valuation Adjustment Process”, I provided a table that reflected five generalized economic scenarios and their accompanying P/E levels. Ranging from great to terrible, the table put some meat on the valuation bone and enabled stock price parameters to be considered. Now let’s take this to another, more complete level.

The above table* takes the five economic scenarios and attaches a probability to each. Moreover, each such economic scenario necessarily includes a rough estimate of the likely operating earnings level for the S&P 500 for each economic situation.

Obviously, one is free to debate, even disagree, with various aspects of the table (the probabilities, the economic scenarios, the operating earnings estimated, the definitions). But I would argue that there is a certain richness in this simple model that, like the equally simplistic discounted cash flow model, captures nearly all of the essential valuation points**.

Investment Strategy Implications

Is it a coincidence that for the past several months the S&P 500 has been oscillating around the 1251 bottom line number noted in the above table? Or, is the market engaged in an internal debate that remains unresolved at the moment: What is the appropriate P/E level for the economic times that we live in?

*click image to enlarge.
**Valuation 101 teaches us that P/Es, like the discounted cash flow method, incorporate the key valuation inputs from the real economy.

No comments: