Let's return to the question of how much investors should pay for growth. Since 1995, Thomson Reuters I/B/E/S has been compiling analysts' consensus short-term earnings growth expectations over the next 12 months (52 weeks since 2005) for the S&P 500 index. Data are also available for long-term growth expectations over the next five years. The latter series peaked at a record 18.7% during August 2000, just when the tech bubble burst. It then declined to a low of 9.4% during May 2009. At the end of May, it was 10.9%.
We can compute a price-to-earnings-to-growth ratio for the S&P 500 using the forward price-earnings ratio and dividing it by long-term expectations. This ratio recently bottomed at 0.93 during the week of Nov. 24, 2011. It is now back up to 1.3. Is that too high? Not really; it is back to the average of this series since 1995. Given that analysts' long-term growth expectations are clearly optimistically biased, think of this average as the “normalized” fair value of the price-to-earnings-to-growth ratio.
In other words, the P/E is just about where it should be in our Rational Exuberance scenario, to which we assign a 60% subjective probability. P/Es exceeding, say, 15 would be more consistent with our Irrational Exuberance scenario (30%).
Source: Ed Yardeni — Ed Yardeni is the president and chief investment strategist of Yardeni Research Inc., a provider of independent investment strategy and economics research for institutional investors.
