Earnings drive stock prices, right?

It's easy to say that the stock market is nothing more than a "casino" that is driven by "speculators," but over the long term, earnings do drive stock prices. So, how do corporate earnings look these days? Actually, pretty good.

We've just wrapped up the fourth quarter 2009 earnings reporting period and 72% of the companies in the S&P 500 beat earnings estimates, according to Thomson Reuters, as reported by The Wall Street Journal. For all of 2009, S&P 500 earnings came in at about $57, up from $49.51 in 2008, but below the peak of $87.72 in 2006, according to Standard & Poor's.  

For 2010, Wall Street strategists expect S&P 500 profits of about $75, according to Barron's. With the S&P 500 closing last week at 1160, this means the index is selling at a price-to-earnings ratio (P/E) of 15.5 based on expected 2010 profits. Historically, based on the trailing 12-months earnings, the long-term average P/E ratio of the S&P 500 was 18.3, according to data from Barclays Capital, as reported by The Wall Street Journal. Therefore, if 2010 profits do arrive as projected, then the current market may be undervalued based on the historical P/E ratio.

But, here's where it gets interesting.

In 1998, S&P 500 earnings were $44.27 while the index closed that year at 1229, according to Standard and Poor's and data from Yahoo! Finance. Yet, last week, the S&P 500 closed at 1160--about 6% below the level of year-end 1998--despite the fact that S&P 500 earnings in 2009 came in at about $57--more than 28% above the level in 1998, according to Standard and Poor's. Even more remarkable, S&P earnings in 1999 were $51.68 (still below 2009's earnings) and the S&P 500 closed that year at 1469, which leaves our current market 21% below 1999 even though last year's earnings were about 10% higher than 1999's.

Are you dizzy, yet?

In short, earnings are significantly higher today than they were in 1998 and 1999, yet stock prices are still lower. This seeming paradox occurred because investors are placing a lower P/E multiple on today's earnings than they did on 1998's or 1999's earnings. That's the good news.

The bad news is an alternative measure of the P/E ratio, which uses 10-year average corporate earnings instead of just the past year, shows the S&P 500 at a P/E ratio of 20.6. Yale economist Robert J. Shiller popularized this measure and the P/E of 20.6 is currently higher than the historical average of 16 using this methodology, according to The New York Times. So, by this calculation, the current market may be overvalued.

So which is it? Whether undervalued, overvalued, or just right, you can find data to support any opinion. Nonetheless, we remain focused on helping you navigate through this uncertainty.

Notes: S&P 500, DJ Global ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.

Sources: Yahoo! Finance, Barron's, djindexes.com, London Bullion Market Association.

Past performance is no guarantee of future results.  Indices are unmanaged and cannot be invested into directly.  N/A means not applicable or not available.