10-YEAR MOVING AVERAGE VS EXPONENTIAL REGRESSION

The following charts are based on Professor Robert J. Shiller's online data base. While Professor Shiller uses a 10-year moving average of inflation adjusted S&P 500 composite monthly earnings to calculate the S&P 500 price earnings ratio, I recommend using the exponential regression of inflation adjusted S&P 500 composite monthly earnings and the inflation adjusted monthly earnings from Cowles and Associates (Common Stock Indexes) for the last 138 years to calculate the S&P 500 P/E (i.e. an exponential P/E).

A 10-year moving average of earnings was used by Benjamin Graham when calculating the P/E ratio for individual companies. While a 10-year moving average can do a good job smoothing out a company's short-term earnings fluctuations it may not be up to the task when dealing with abnormally high or low composite stock market index earnings over extended periods of time. An exponential P/E, on the other hand, is not unduly influenced by long-term stock market earnings trends.

Because Professor Shiller's data is inflation adjusted the exponential P/E will react to inflationary trends. Rising inflation will cause the exponential monthly earnings trend line to rise, which will result in the current exponential P/E being adjusted downwards. Historic exponential P/E will remain relatively stable due also to the upward adjustment of the past S&P 500 index prices.

While the vast majority of investors find the scenario of a S&P 500 P/E of 10 extremely unlikely (no matter what earnings measurement one uses), I believe that if a given outcome is possible, even if highly improbable, it must be taken into account. Given high inflation, the S&P 500 does not need to fall to 499 to hit a P/E of 10 (based on July 3, 2009 exponential earnings of $49.99). The resulting rise in inflation adjusted exponential earnings could push an S&P 500 P/E low of 10 to an S&P 500 level of 600, 700 or more.

METHODOLOGY

The exponential monthly earnings will change over time due to future monthly earnings, adjustments for inflation and compounding. I plan to update the exponential monthly earnings on a quarterly basis to reflect new earnings and inflation with small weekly changes during the quarter to reflect compounding.

Professor Shiller's S&P 500 monthly prices are based on a monthly average of daily closing prices. Because I wish this web site to show the current performance of the market, I plan to update the web site weekly using the most recent weekly S&P 500 closing price (closing price of the last business day of the week) with the prior monthly prices based on Professor Shiller's monthly average of daily closing prices. Between weekly updates, in order to obtain the current S&P 500 exponential P/E, the current S&P 500 price can be divided by the monthly exponential earnings found in the table at the top of this web page.

For illustrative purposes I have substituted the S&P 500 closing low of 676.53 on Monday, March 9, 2009 for the March 2009 monthly closing price and also substituted the October 9, 2002 closing low of 776.76 for Professor Shiller's October 2002 monthly average price. It is rather hard to see the current S&P 500 price and exponential P/E values on the 1871 - 2010 charts so I am including charts for 1980 - 2010.

S&P 500 EARNINGS TREND

I would like to make one observation. The S&P 500 monthly earnings trend line chart representing the 10-year moving average of monthly earnings relative to the exponential regression of monthly earnings is probably a good pictorial representation of the history of economic globalization. What concerns me is that during times of economic stress countries tend to focus myopically on what they perceive to be in their economic self-interest. If we head down the slippery slope of protectionism or we continue running profligate deficits that severely devalue the dollar, then we could be looking at a very long period of depressed corporate earnings.