Financial commentary frequently misuses the market's collective Price-to-Earnings (P/E) ratio when aggregating earnings. While the forward P/E ratio is a common and intuitive valuation tool, typically based on consensus forecasts of earnings for the next 12 months, the method of aggregation can be fallacious, particularly during recessions. This error stems from market strategists aggregating analysts' estimates of individual stocks' future operating earnings into a broader market P/E multiple. Operating earnings often exclude non-recurring, extraordinary items, which tend to be negative. Companies disproportionately exclude negative extraordinary items more often than positive ones, leading some to refer to operating earnings as "earnings before whatever went wrong." Strategists, while aware that some companies will disclose unexpected declines, find it difficult to predict which ones.
The S&P 500's aggregate operating earnings for 2023 were estimated at $226, a 13% growth over 2022, resulting in a current market forward P/E multiple of 17 times. However, if actual reported earnings for 2022 only matched the estimated $181, the current price-to-forward earnings ratio would rise to 21. If a widely expected recession leads to a 20% decline in S&P 500 reported earnings from 2022 levels, a much less severe drop than an average recession, the ratio would become 26, indicating the market is not a bargain. This suggests aggregate forward earnings estimates tacitly assume no future drag from inevitable, predominantly negative extraordinary items.
Historical data from S&P shows that aggregate S&P 500 reported earnings over the past 34 years have been 13% lower than collective operating earnings, with this gap widening significantly during recessions. For example, during 2001 and 2002, operating earnings exceeded reported profits by 57% and 70% respectively, by 233% in 2008, and by 30% in 2020. After the COVID-19 outbreak, reported aggregate earnings plummeted to $94 per share but rebounded to $198 in 2021. For 2022, reported earnings were expected to drop by 9% to $181, while operating earnings consistently exceeded reported earnings by 30% in 2020, 5% in 2021, and likely 10% in 2022. Analysts' current focus on 2023 earnings estimates continues to ignore these predictable "non-recurring" losses, making the market appear cheaper than it truly is.
