Since I started writing The Seven Signs of a Changing Economy™ updates, as the “tail” end data flow to my best-selling book, Surviving the Storm (McGraw-Hill 2007), fifteen years ago, there has always been an “*” disclaimer at the end of these reports.
If you’re “normal” you likely have never read it! But now it matters, so I will open with the significance of that “*” now.
*The Rule of 20 is in this calculation implying, and using, a price/earnings ratio, which is the valuation ratio of a company’s current share price compared to its per-share earnings. Both EPS and the multiple could drop. The earnings could be reduced due to the consumers spending less.
The multiplier, or how much an investor should pay for a company based on their earnings, would be less in a weak economic back drop.
Above in Sign #1, Personal Consumption Expenditures (PCE) it is becoming clear that inflation is reducing PCE. As you will read below in Sign #7 (Inflation/deflation and GDP), our economy is now in a recession. The widely accepted definition of a recession is two consecutive negative (contracting) quarters in economic growth. The normal “wild card” is how much or how little do you pay for a company’s future growth without knowing how deep or how long a recession might be.
Let’s run the FMV numbers two ways to help us gain more clarity on both where we are for “Fair Market Value” (FMV) now and where we might be in November 2022 as the inflation, interest rate hikes, recession and political mudslinging collides.
To calculate FMV, I will use “The Rule of 20”, a commonly accepted quick calculation.
To use “The Rule of 20” you just subtract the inflation rate from 20. I will use the same inflation rate the BEA used in calculating the Gross Domestic Product (GDP) for the 1Q2022 “Third Estimate” released June 29, 2022, of +7.60%.
The result becomes your multiplier and is multiplied by the respective year’s earnings per share to calculate the Fair Market Value (FMV).
This month’s calculation is going to sting once again as the inflation rate remains elevated at +7.60% and up from +4.40% a few months ago.
Take a peek!
- 20 – 7.60 = 12.40x
- 2022 S&P 500 earnings estimate $239.93 (Source: Yardini Research, 6/27/2022)
- 2022 S&P 500 Fair Market Value estimate $239.93 x 12.40 = S&P 500 (FMV) 2,975.12
As of 7/6/2022, the S&P 500 trades at 3,831.44, or a 28.78% premium to S&P 500 (FMV) of 2,975.12.
The current 7/6/2022 price of the S&P 500 at 3,831.44 divided by earnings per share estimate of $239.93 equals a Price to Earnings (P/E) ratio, a measure of risk, of 15.97x. Per JP Morgan Guide to the Markets, 3/31/2022, the 25-year average P/E for the S&P 500 is 16x. Thus, we rest today at the 25-year average.
The multiplier of 12.40x above seems reasonable to use in our “what about a recession” comparison. So, the question could be how much of a reduction do the earnings of Corporate America take in a moderate economic contraction? Let’s suppose a 15% reduction is reasonable. Here is what that might look like on an FMV comparison.
- 20 – 7.60 = 12.40x
- 2022 S&P 500 earnings estimate (reduced by 15%) would be $203.94
- 2022 S&P 500 Fair Market Value estimate of $203.94 x 12.40 = S&P 500 (FMV) 2,528.87
Like above, the S&P 500 on 7/6/2022 trades at 3,381.44, or a recession adjusted premium of 51.51%. With adjusted EPS the current price to recession adjusted EPS, the P/E ratio, would be 18.78, still about a 17.41% premium to the 25-year average of 16x. Ugh!
As you know from the WSG Weekly Update, The WSG monthly conference call and these Seven Signs, “the” question is this: Are these “knowns” and already built into the current valuations? No one knows and no one knows the future, so we remain very focused on corporate earnings, which, for now have not contracted, yet the data flow suggests they are under pressure.
I’m interested in your thoughts, comments and observations. Feel welcome to call, email or stop by the office and say Hi.
James O. Lunney, CFP®
CERTIFIED FINANCIAL PLANNER™ Professional
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing involves risk including loss of principal. No strategy assures success or protects against loss.