S&P - As of March 6, 2009

Please click the graph to view better - note the orange line is the implied volatility and the blue line is the historical volatility.

The technicals for the S&P are clearly broken, leaving many traders speculating that the S&P can test 600. Only time can tell; however, I will highlight some framework, behind determining "worst case" and "best care" scenarios for the S&P, based on a P/E valuation.

In July 2007, the S&P had peak operating earnings of $91; however, since that peak, earnings have fallen dramatically, leaving an analyst concensus of about $66 (estimate), for 2009 S&P operating earnings. There are two areas that have analysts/traders debating: the financial write-downs and provisions to apply to those operating earnings and the proper multiple to assign to the operating earnings.

Write-downs and provision estimates: Currently many analysts are estimating operating earnings between $62-$70 on the S&P but that excludes the write-downs and provisions, set by the financial sector. Some optomists believe that write-downs and provisions will be $-10, while more bearish analysts feel it could be $-30. That leaves a wide range between $32-$60 operating earnings on the S&P for 2009. Looking at the various sectors that make up the S&P, many sectors will have significant reductions in Operating Earnings. Energy, Basic Materials, and Consumer Discretionary seem to be the top sectors to be hit in 2009, while Healthcare, Utilities, and Consumer Staples should exhibit flat or low growth. Since 2007, there has been roughly $1.2 trillion in global finanical write-downs and many analysts believe that number could easily double by the middle or end of 2010. The key questions seem to be, "How much of these losses and provisions will take place in 2009?" and "At what point will investors begin to "overlook" these write-downs and provisions and try to look at 2010 earnings?"

P/E Multiple: There is much debate about applying the proper trough multiple to the S&P. Some analysts believe you can apply a traditional bear market multiple of 14-15x, while others believe it should be lower, between 9-10x, due to weak economic conditions. If you take an average multiple during the Great Depression and World War I, you will get a multiple of 12.6x.

Now applying these two factors creates various scenarios. The first decision involves making an operating earnings projection. The main options are:
1. 2009 Operating Earnings Estimates Including Financial Sector Provisions/Estimates
2. 2009 Operating Earnings Estimates Excluding Financial Sector Provisions/Estmiates
3. 2010 Operating Earnings Estimates Including (or Excluding) Financial Sector Provisions/Estimates.

Once determining the operating earnings estimate, make an assumption on the multiple, to calculate S&P projections.

This is one way to determine an S&P range; however, there are other methods like the Fed Model, DDM, or Reversion of P/E multiples over past time periods, to get a fair value estimate.