I just watched a useful video by ReSolve Asset Management on the P/E 10 ratio (or CAPE 10), which discussed the rising trend in this ratio (click here for video).
It made me curious to see the impact of the depressed earnings of the financial crisis on the P/E 10, in particular because these earnings will begin to fall off beginning next year. Below are the annual S&P 500 earnings for the past 10 years up to Dec 2016 (data from www.multpl.com):
Dec 2016 95.76
Dec 2015 89.46
Dec 2014 106.54
Dec 2013 105.13
Dec 2012 92.13
Dec 2011 94.12
Dec 2010 86.29
Dec 2009 57.71
Dec 2008 17.31
Dec 2007 77.05
As you can see, 2008 and 2009 earnings were disastrous. What will happen to P/E 10 when these earnings are replaced with earnings in 2018 and 2019? Of course, we have no idea at this point. They could be recessionary earnings as well and equally disastrous.
For entertainment purposes though, let’s assume that S&P earnings between 2017-2019 are flat with 2016 earnings. As at Dec 2016, the average annual earnings over the prior 10 years was 81.2. If we apply our assumption of flat earnings between 2016 and 2019, average annual earnings in Dec 2019 would jump to 95.7. This would be a 16.5% bump to the 10-year average earnings from Dec 2016. Note that these numbers are not inflation adjusted, but sufficient for illustrative purposes.
If the S&P 500 were to trade flat between now and Dec 2019, the P/E 10 (again not inflation adjusted) would drop around 14%. It would still be elevated by historical standards, but a little less so.
I understand that this is cherry picking data and I am not trying to justify current valuations which are above historical norms based on a number of metrics (EV/EBITDA, price/sales, price/book, etc.). I also know that valuation measures have zero utility for short term market timing. It is simple to show that the P/E 10 ratio “could” correct over the next couple of years and look less obscene as 2008 and 2009 earnings fall off, even with zero earnings growth.