Could the S&P Really Dive 20% in 4 Months?

by James Brumley | August 16, 2012 8:40 am

Nobody loves a big prediction more than I do. On the other hand, I can’t help but wonder how many extreme predictions are now being made just for the sake of a big prediction, and garnering attention the media loves to give their creators.

And yes, there’s one in particular I’m taking issue with right now.

He’s no Doomsday Prophet like Nouriel Roubini or Paul B. Farrell over at MarketWatch, nor is he a seemingly perma-bear economist like Robert Shiller, who can run any set of numbers through a formula and eventually make them bearish. But, Morgan Stanley analyst Adam Parker has turned a few heads lately with his year-end target price of 1,167[1] for the S&P 500.

Not that I think everything is rosy out there for the economy, but for perspective, that would mean a 20% drop from the S&P 500’s current price in a little more than four months. Yes, we’ve seen worse, but it’s a rarity — and nobody ever actually sees pullbacks of that magnitude coming. Even more bizarre than the prediction is the basis for it.

Is there even a smidgen of a chance Parker could be spot-on with his wild outlook this time around?

Crunching the Numbers

I’ll say this much for Adam Parker: Unlike the majority of his analytical peers, he’s not just throwing darts and picking a number. There’s a method to the madness. In this case, the method is earnings-based. Problem: He’s looking for a pretty steep dip in corporate earnings, and has assumed the S&P 500 will be priced unusually low when 2012 comes to a close.

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Simply put: Were the S&P 500 a company, Parker is saying it will earn $100 per share in 2012.

For perspective, with 93% of companies having reported last quarter’s earnings, the S&P 500 will almost certainly earn $25.48 for Q2. During the past four quarters (Q3 2011 to Q2 2012), the S&P 500 has earned $98.74. Last year, it earned $96.44.

As it stands right now, the S&P 500 is priced at 14.2 times its trailing earnings. Its forward-looking (2013) P/E ratio is 14.05. That’s already significantly below the long-term average of 15.

It begs the question: If the index is even on pace for a modest earnings gain, what’s going to drive this huge drop?

Parker has an answer — you might or might not agree with it.

What to Fear

While he hasn’t come out and said so explicitly, Parker hints of the possibility that the S&P 500 doesn’t have a prayer of meeting 2013’s currently projected per-share profit of $115.28. Parker’s guess: $99.

The collective market still broadly believes it can reach that $115.28 mark, mind you, but if things continue to sour — economically speaking — during the next four months, and investors start to feel that current outlook is out of reach for next year, it might start a preemptive selloff for stocks.

See, while we love to talk about historical earnings, stocks are generally handicapped based on forward-looking profits … at least as well as traders can handicap them. If things look grim for next year, the market will price that in beforehand.

Yet, the numbers still don’t quite make sense. If the S&P 500 does indeed only earn $99 in 2013, and does indeed fall to Parker’s target of 1,167, it’s going to be trading at a forward-looking P/E of 11.8 when December is over. Folks, the S&P 500’s operating P/E ratio hasn’t been in the 11’s since 1989. I never say never, but when I start to hear market valuations are going to hit levels we haven’t seen in more than two decades, my inner skeptic rears its questioning head and has to wonder aloud if this is all just a case of someone needing attention.

For Parker’s S&P 500 forecast to be plausible based on history, the economy is going to have to get very, very nasty. I’m not saying it’s great, but I don’t see economic Armageddon on the horizon. Just malaise.

Bottom Line

Take every forecast, including mine, with a grain of salt. A lot of them seem logical — and therefore scary or encouraging — at first glance. When you really dive into the numbers, though, they don’t always add up.

I’m not saying the S&P 500 can’t tumble to 1,167 in four months. I’m just saying I don’t think the math, the odds and history support that prediction.

  1. year-end target price of 1,167:

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