Thursday, 27 June 2013

The Market Multiple On The S&P 500 Can Be Explained: P/E Ratios Are Inversely Related To Future Federal Spending

By Lance Brofman

Any period's valuation of equities is determined by corporate profits and the multiple the market is willing to place on those profits. Macro economists typically take a top down approach to estimating profits. Determinants are typically GDP, labor cost, and inflation. Market strategists typically adopt a bottom up estimate of profits by aggregating views of industry analysts.

A much less precise exercise is involved in determining the market multiple. Assumption of the multiple for any given year typically relate to the position of the market relative to the business cycle. Other inputs tend toward interest rate assumptions and the degree to which investors are under or overexposed to equities.

In this note, we take a more rigorous approach toward estimating the market's multiple. There is more than 50 years of data on the price to earnings multiple of the S&P 500. The S&P 500 is widely regarded as the best single gauge of the large capitalization U.S. equities market since the index was first published in 1957. The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities. Published data on the earnings of the S&P 500 are available from 1960 forward.

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