How much should stocks correct? Less than you may think: Nir Kaissar
One way to answer that question is to see if stocks are unusually expensive relative to their fundamentals and then estimate the declines required to bring them back to more normal levels. I did just that following Monday’s 3% slide in the S&P 500 Index, expecting to find a frothy market packed with overbought stocks. What I found surprised me.
I looked at analysts’ consensus long-term earnings growth forecasts for each company in the S&P 500. This is the estimated earnings growth over the company’s business cycle, which is typically three to five years. I used those growth rates to calculate each company’s future earnings per share — let’s call them long-term earnings — and then used that to calculate a price-earnings ratio for each company — I’ll call it the long-term P/E ratio.
I had to exclude 58 companies for which estimates were not available, but collectively their weighting is just 6% of the index, so most of the S&P 500 by market value is represented in my calculations.
With my long-term P/E ratios in hand, I then had to settle on the “right” ratio. There are many disagreements about where fair value lies, but the market hints at an answer. One clue is that the S&P 500’s average P/E ratio based on forward earnings is 18 times since 1990, the furthest back the data goes. A second is that the average long-term P/E ratio for S&P 500 companies tends to hang around that multiple and is now only modestly higher at 20 times.
With that as background, I decided on 18 times as my bogey for long-term P/E. To my
