From the February 01, 2012 issue of Futures Magazine • Subscribe!

How to market-time with stock fundamentals

According to Standard & Poors, on Dec. 20, 2011, the S&P 500 had a market capitalization of $11.238 trillion. The four largest stocks in the index were Exxon, Apple, IBM and Chevron (see “Big money,” below). For example, Exxon had 4.790 billion shares outstanding. With the stock trading at $82, Exxon’s market capitalization was $329.780 billion. The stock’s weighted capitalization with respect to the index itself was 3.49%.

One closely watched calculation is the S&P 500 earnings data. The weighted capitalization figure is used to arrive at this number. First, we calculate the earnings per share (EPS) of each company by dividing each company’s net earnings by its number of outstanding shares. Next, we multiply the EPS by a weighted factor for a given stock to get a weighted EPS. We then calculate the S&P 500 earnings by summing the weighted EPS values for each company.

Earnings are relative over time because of inflation, so $2 per share in 1980 is not the same as $2 per share in 2011. Hence, we must adjust earnings for inflation. This constant dollar earning figure compares the real value of the price/income from the nominal value point of view. For instance, this method compares the purchasing power of a typical first job in 1957 with the purchasing power of a typical first job in, say, 1986. Likewise, it determines whether a gallon of gasoline in 1972 was costlier than today by comparing the hours of work required to earn the money needed to buy the gas.

Converting nominal to constant dollar values makes the comparison of the salary data possible. Using the Bureau of Labor Statistics inflation calculator, we can see that $5,000 in 1957 is equal to $19,502 in 1986 dollars, and that $18,000 in 1986 is equivalent to $4,615 in 1957 dollars.

Robert Shiller is a well-known analyst who has popularized what has become known as the Shiller P/E Ratio. For this calculation, Shiller uses quarterly earnings from Standard & Poors’ website and the monthly average of daily closes for the S&P 500 index. From the quarterly data, he interpolates monthly earnings. The daily closes and earnings figures are adjusted for inflation via the consumer price index (CPI) to get real earnings.

The Shiller P/E Ratio has been used and interpreted for the S&P 500 for years. Its current value is about 20.75, which is 30% higher than long-term average value of approximately 16. This suggests stocks in the S&P 500 are overvalued.

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