Although there’s a massive gap between operating and adjusted S&P 500 EPS, both numbers suggest that the index’s valuation is high, say analysts at Goldman Sachs. Their year-end target for the S&P is 2,100, which suggests 4% upside to the index and a 7% P/E contraction to the current 17.1 times their estimate of $123 per share in operating earnings.

S&P 500 EPS

The S&P pulled back a bit today in late morning trading but remains above 2,000 at 2,010.35 as of this writing.

S&P 500 EPS show index is overvalued

In a report dated March 14, Goldman analyst David Kostin and his team point out that there was a huge gap of $18 between operating and adjusted earnings for the S&P 500 last year, with the former at $100 and the latter at $118.

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They said this is the second-biggest gap in 25 years, adding that half of the difference was due to impairment charges reported by companies in the beleaguered Energy sector. Another major factor is share-based compensation reported by Technology firms.

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As a result, they’ve slashed their estimate for the operating side of S&P 500 EPS from $117 to $110 per share with Energy accounting for $6 of that cut. Although they’re expecting a 10% increase in operating earnings for the index this year, they project only a 1% increase in adjusted earnings, which they now estimate at $119 per share.

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They add:

“The current S&P 500 valuation expansion cycle that began in late-2011 has seen the forward P/E rise by nearly 60%, and has persisted more than three times longer than the typical 16-month expansion. Additional Fed interest rate hikes add to the case against continued valuation expansion. Both the aggregate S&P 500 index and the median stock trade at above-average multiples compared with history.”

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Not a “normal” time

The Goldman team also discusses the difference between using operating and adjusted numbers for their S&P 500 EPS estimates. They prefer using operating numbers for several reasons, one of which is the election. They add that “in normal times,” an election’s outcome might not even matter. However, this time isn’t “normal,” as over the last 25 years, the gap between operating and adjusted S&P 500 EPS has averaged only 4%. Further, this is only the third time since 1990 that the gap between operating and adjusted earnings for the index has been higher than 10%.

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The only time when the gap between operating and adjusted earnings was higher than it was last year was in 1991 when it was a record 31%.

Macro factors affecting S&P 500 EPS

The Goldman team sees real gross domestic product growth in the U.S. as being the biggest macro factor in their S&P 500 EPS model. They estimate that every change in the metric of 100 basis points amounts to a $5 change in earnings for the index.

Interest rates are also a factor, albeit a small one, as they estimate that every 100 basis points of change in bond yield on U.S. Treasuries has an impact of 50 cents per share on S&P 500 EPS. Further, they say investors are overestimating the impact of interest rates on earnings, although the Financials sector’s profits are greatly impacted by them, possibly by about 4%.

Other impacts on earnings for the S&P 500, according to Goldman analysts, include oil prices, as every $10 per barrel shift in crude has a $4 impact on overall EPS for the index, they said, although the impact is obviously much bigger for the Energy sector.

U.S. dollar shaves 7% of S&P 500 EPS in Q4

The U.S. dollar has an impact as well, which Kostin and team estimate at $3 per share on S&P 500 EPS for every 10% shift. They expect the U.S. dollar to appreciate 9% on a trade-weighted basis over the next year, as they expect the Federal Reserve to tighten again in June, versus Morgan Stanley’s expectation that this won’t happen until later in the year. They expect the European central bank and Bank of Japan to keep rates low, noting that differentials in rates will cause the U.S. dollar to strengthen.

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They add that the dollar strength has the greatest impact on sectors that make big portions of their revenue outside the U.S.

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S&P Capital IQ Senior Analyst Lindsey Bell pegs the U.S. dollar’s impact on fourth quarter S&P 500 EPS at 7% as we close in on the end of the reporting period. The current estimate represents a 4.3% year over year decline at $29.25 per share, marking the biggest decline for the index since 2009. Despite the decline, earnings in general have come out ahead of initial estimates, although sales are coming up short at a 3.5% decline, marking the fourth quarterly decline in a row.

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