What’s Really Happening Out There

…What’s really happening out there is a freefall of corporate earnings unlike anything we’ve ever seen. The single fastest drop they’ve suffered in recorded history…

Earnings Fall off a Cliff…But What About Prices?

If analyst estimates remain on point, then Q3 of 2009 will see the first 12-month period in which earnings run negative.

But that doesn’t make any sense!

If earnings were really falling so fast, then why are stock prices rallying? It’s not like we’re all looking at some rosy, tech-boom future. So what’s the deal? Is the “Green Shoot” mentality really that strong…is it really that irrational?

In a word, yes. But here are a few more words…

As I mentioned above, P/E could be “cooked” in any number of ways. It could be calculated over a 5- or 10-year period. It could calculate negative earnings as zeroes. Certain analysts might quarantine the bank stocks in their evaluation. Any number of rabbits could be pulled from any number of hats to generate any P/E you want to look at.

The possibilities are endless.

But…what if we calculated current P/E based only on this most recent batch of earnings numbers and analyst estimates for the future?

(I’ll ask you to hold your breath here…)

Accounting for negative earnings reports for the S&P 500 over the last several quarters, the S&P 500 is now trading at 131 times earnings!

Of course, it's not the same as when the index traded at 44 times earnings back in the days of the dotcom bubble. That was a peak P/E ratio compared to peak earnings. In that case, both Earnings and P/E ratios eventually fell as the S&P plummeted over 45%.

In fact, high P/E ratios can sometimes presage a good opportunity to buy…

That's when earnings simply fell faster and farther than share prices... and earnings were on the verge of a recovery. But we don't think now is one of those times.

When we look at expected earnings for the S&P 500, we see forecasts of 28.5 for 2009 and 39.3 for 2010. That would put the current value of the S&P at about 32 times this year's earnings and 23 times next year's earnings. Those are numbers far above the long-term trailing P/E average of 16.

They are farther still from the single digit market P/Es we have seen at previous major market bottoms.

What's more, market history also shows that when you buy at a P/E above 20, you can expect to see negative share price action over the ensuing 3-, 6- and 12-month periods.

Last but not least, we find the current level of the S&P in relation to estimated '09 and '10 earnings to be especially pricey for a market that still has so much macro-economic risk in it.

So today we’ll remind you of the old adage; “Sell in May and go away.” Seems that could be a good strategy this time around.

Hmmm…I wonder how much those S&P puts are going for…