Earnings and the Price Earnings Ratio.

One of our main tenants is that stock prices follow earnings.  That is why we place such an important emphasis on developing an earnings hypothesis each year for the S&P 500.  Here's data courtesy of Moneybeat.com that shows why we find this to be so important.

As Moneybeat points out, "the S&P 500 has closely tracked expectations for future profit growth throughout much of the current bull market.  The volatility in the summer of 2011 marking the only sustained period of time where the two trends differed from one another."

Next we want to take a look at historic Price Earnings {PE}ratios.  This chart is courtesy of Chart of the Day.com and is one that we've shown before.

According to the folks over there.  "Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1900 into the mid-1990s, the PE ratio tended to peak in the low to mid-20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s), surged even higher during the dot-com bust (early 2000s), and spiked to extraordinary levels during the financial crisis (late 2000s). Since the early 2000s, the PE ratio has been trending lower with the very significant but relatively brief exception that was the financial crisis. More recently, the PE ratio has moved significantly higher and is fast approaching the low 20s -- a level around which several stock market rallies stalled (e.g. 1929, several from 1958 to 1972, and 1987)".

While I don't know exactly what the fellows that composed this chart use as data, I strongly suspect that these are trailing earnings as according to our 2013 estimates stocks are trading with approximately a 15.5 PE on our forward midpoint estimate of 106.50.  Either way this data would seem to argue for a more neutral stance on the market.

However we should note two things.  Stocks can expand their PE's, particularly if investors sniff out better economic prospects.  We have seen periods in the past where stocks in an economic expansion traded with forward PEs between 16-18.  During much of the 1980's-90's bull markets stocks traded this way.  A higher PE may also be justified in an extremely low interest rate environment. The other possibility is that the "E", the earnings part of this equation is wrong.  If for example S&P 500 earnings actually approach something closer to what seems to be Wall Street consensus estimates of around $110 for 2013 on the S&P 500  then stocks are currently trading with a PE under 15.  This can work the other way as well.  If investors start to believe that earnings estimates are too high then stock prices are vulnerable to a correction.  

The more elevated PE given the experience of the past five years is one of the reasons that we think this will be a very important upcoming earnings season.  Stocks have much less room for error if the economy or companies start to disappoint.

Links:  Marketbeat.com  Rally in Three Charts.
            Chart of the Day:  PE Ratios

*Long ETFs related to the S&P 500 in client and personal accounts.