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Sound Advice: August 26, 2020

How To Forecast Future Stock Prices . . . Usually

Wall Street research can be extraordinarily useful in helping to gain a better understanding of the inner workings of companies.  Having been on the research side of the investment world for many years, I've had extensive experience in exploring the nuts and bolts of dozens of companies, both through analysis of numerous financial reports and regular contact with corporate executives.  Some of it was useful; some was not. 

In all cases, the goal was to come up with estimates of where company earnings were likely to be in the year ahead and the years beyond. As analysts, we looked for consistency of progress and the potential to grow at above average rates.  The task of coming up with these kinds of conclusions was a matter of translating discussions of ongoing operations and developments into numbers that made sense.

Once that was done, we viewed the current analysis against the backdrop of the past.  The range of past valuations often provided an indication of what might lie ahead.  So if the price-earnings ratio (p/e) had previously ranged  between 15 and 18 times earnings, one could project future prices by multiplying future earnings by the historical p/e.

This is not a flawless equation.  For one thing, overall stock valuations are heavily influenced by the current level of interest rates.  When rates are low, as they are now, valuations tend to be high.  And vice-versa.  For another, there are many instances when interim developments disrupt a lengthy record of progress, which invariably has a significant negative impact on stock prices.  When that happens, you can throw the historical range out the window.

Still, the equation is quite useful from a macro view.  To get a clearer understanding of the relationship, I compared the actual levels of the S&P 500 Index with calculated values.  Those calculated values were the products of the earnings of the S&P 500 times the upper end of the historical valuation range.  Over the period, there has been a significant correlation between the two, though there have been a few times when it was clear that valuations were stretched in the extreme.

The outstanding example of excess was during the era of 1999-2000, when the S&P turned out to be overvalued by almost 50%.  The debacle that followed corrected that aberration, but it took more than a decade before the S&P 500 was able to move to new high ground.

The S&P plunged again in 2008-2009, virtually in line with the change in underlying earnings.

Where are we today?  That depends on where S&P earnings are likely to end for the full year, but it's hard to view the index's current position as other than richly valued.  At the moment, Wall Street analysts are estimating earnings at $120 a share for 2020, $150 a share for 2021, and $175 a share for 2022.  Based on those estimates, the index, now above 3400, is several hundred points higher than the value calculated by the earnings currently projected for 2022.

Wherever the actual earnings level for this year and the next few years ends up, it seems clear that prospective market gains ahead will be leaner than those recently registered.   

N. Russell Wayne, CFP®


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