Blog - Investing Notes

March 13, 2008 - Real Earnings Yield Model Scenarios

A reader posed the following question:

"What would be the current S&P 500 index target according to your model if expected earnings were flat? Could you provide some scenario analysis based on your model relative to different expected earnings growth rates (+5%, 0%, -5%, -10%) and different realized inflation rates (1.5%, 2.5%, 3.5%)?"

For this analysis, we use the short-term version of the Real Earnings Yield (REY) model based on total inflation rate because the REY model generally outperforms the Reversion-to-Value model in fitting historical data and because we have better total than core inflation rate forecast error data. We consider four S&P 500 operating earnings scenarios and five total inflation rate scenarios, with focus on the most optimistic and pessimistic combinations. Using projections through the end of 2008, we find that...

The following chart summarizes the four S&P 500 operating earnings growth scenarios in terms of year-over-year quarterly growth over the next three calendar quarters, as follows:

• Scenario E0 reflects the latest available bottoms-up S&P 500 operating earnings forecast from Standard and Poor's.
• Scenario E1 is an optimistic scenario that assumes actual earnings growth will be 5% higher than forecast for each quarter.
• Scenario E2 is a pessimistic scenario that assumes year-over-year declines of 10%, 10% and 5% for the next three quarters.
• Scenario E3 is a very pessimistic scenario (but not as bad as what actually happened in the fourth quarter of 2007) that assumes year-over-year declines of 20%, 20% and 10% for the next three quarters.

Next are the total inflation rate scenarios.

The next chart summarizes the five total inflation rate scenarios, as follows:

1. Scenario I0 is the current inflation rate forecast, as generated by simple extrapolation of the recent trend.
2. Scenario I1 is the current forecast minus one standard deviation of forecast errors based on recent data (optimistic).
3. Scenario I2 is the current forecast plus one standard deviation of forecast errors (pessimistic).
4. Scenario I3 is the current forecast minus two standard deviations of forecast errors (very optimistic).
5. Scenario I4 is the current forecast plus two standard deviations of forecast errors (very pessimistic).

The scenarios diverge because the forecast errors tend to be larger for longer-range forecasts.

Next are REY model projections based on combinations of earnings growth and inflation rate scenarios.

The final chart depicts various REY model projections based on combinations of earnings growth and inflation rate scenarios, as follows:

• Scenario E0-I0 is the current projection of the REY model based on total inflation rate.
• Scenario E1-I0 combines the optimistic earnings growth and the current inflation rate scenarios.
• Scenario E2-I0 combines the pessimistic earnings growth and the current inflation rate scenarios.
• Scenario E3-I0 combines the very pessimistic earnings growth and the current inflation rate scenarios.
• Scenario E1-I3 combines the optimistic earnings growth and the very optimistic inflation rate scenarios.
• Scenario E2-I2 combines the pessimistic earnings growth and the pessimistic inflation rate scenarios.
• Scenario E3-I4 combines the very pessimistic earnings growth and the very pessimistic inflation rate scenarios.

Obviously, wide-ranging assumptions result in wide-ranging model outputs, from recovery of market highs to give-back of three years of gains.

Note that investors appear to have been relatively insensitive to total inflation rate fluctuations over the past three years, instead focusing on variations in the core inflation rate. A persistent trend up or down could cause investors to elevate focus on total inflation rate (with the core inflation rate responding but lagging), thereby amplifying the effect of changes in the total inflation rate.

In summary, beliefs about future corporate financial performance and about the future discount rate are critical to investors who make decisions based on fundamental valuation.

For related research, see Blog Synthesis: Gunning for the Fed Model?.