Using bottom-up estimates, the S&P 500's forward price/earnings is currently 10.8x, which history suggests is relatively cheap, especially considering falling inflation expectations. (Consistent with slowing world growth and lower energy prices, the average economist surveyed by Bloomberg expects inflation, as defined by the CPI, to drop from its current reading of 4.9% to 2.5% next year; and the market-based 10-year TIPS spread has already declined to just 0.7%). The problem, however, is given the low visibility and rapidly slowing world economy, next year's earnings estimates still remain too high, in our view.
* Yet, even if we use much more conservative numbers, and assume 2009 earnings are reduced from the current Street estimate of $95 to just $60, this would place the S&P 500's P/E at a still reasonable valuation level of 14.2x. (According to Strategas Research, when the inflation rate has been between 2% to 4%, the S&P 500's average P/E has been 17.4x; similarly, when inflation has been between 0% to 2%, the market's multiple has averaged 18.3x).
* An alternative valuation tool, the price/sales ratio--which is a bit more stable than the price/earnings ratio, is subject to less accounting manipulations than other metrics, and overcomes some of the obstacles presented by the huge write-offs in Financials--is currently at a level of 0.82x, approximately 20% below its median since the fall of 1979 (see Figure 1). To be fair, this data series encompasses most of the great secular bull market that began in the early 80s.
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