The Flinchum File

Thoughtful Economic Analysis and Existential Opinions
Subscribe to the Flinchum File
View Archives

Still NOT Different This Time

A respected Wall Street analyst just predicted the Dow would end the year at 27,000.  This would require 25% growth in six months.  I cannot quite get my head around that.

For the nerds out there, the formula most commonly used to forecast the stock market is to multiply  earnings-per-share (EPS) times the price-earnings (PE) ratio.  To find EPS, you take average net earnings and divide it by the average number of shares outstanding.  To find PE, you take the current index value (say, the S&P) and divide it by the EPS.  It answers the question of how much will an investor pay for $1 of earnings?  A PE of 18 means an investor will pay $18 for each dollar of EPS.

The analyst’s forecast was based on his belief that EPS would continue to increase at a 6-8% year-over-year rate and, that the PE of last year’s EPS would increase from 18 to 20 times next year’s EPS.  That EPS growth rate is more hope than analysis, I believe.  EPS bottomed out in Q1 of last year, especially for energy companies.  So, year-over-year comparisons will look less and less attractive.  While the PE of last year’s earnings looks fully priced, the PE for next year’s earning looks historically high.  Take a look at this graph:

Chart of the Day
(This graph uses last year’s EPS, causing a higher PE than using next year’s higher estimated EPS.)  
The point is that anything above 21 or 22 times EPS is getting into thin air.  That doesn’t mean it cannot continue to increase, only that it can not be sustained for an indefinite period.  As before, the PE multiple must return to Earth . . . but not today.