Analysis Overview – Amidst volatility, the S&P 500 index has largely been range bound in the last 24 months with the index returning 9.5% during this period. This article discusses historical and forward valuations for S&P 500 to conclude on the potential direction for the index in the next 12 months.

S&P 500 PE Valuations (1988 to 2017E) – The chart below gives the PE valuation for the S&P 500 index from 1988 to 2017E.

Excluding the 2008 aberration, the S&P 500 index has traded at an average PE valuation of 21.0. If 2016 and 2017 EPS estimates of $111.5 and $126.5 are considered, the S&P 500 index is trading at 2016 and 2017 PE valuations of 18.4 and 16.2 respectively.

Therefore, if the estimates hold true, S&P 500 is still trading at valuations that are below the historical average. From this perspective, the index is not overvalued and strong EPS can trigger upside for the index in the next 12-24 months.

However, there are few points of concern and I want to elaborate on these points before concluding on where the S&P 500 index is headed in the coming quarters.

First, as the chart below indicates, the operating margin for S&P 500 has been shrinking in the recent past and 4Q15 operating margin is the worst in the last 12 quarters.

With a strong dollar impacting earnings, the industrial commodities sector under pressure along with the energy sector and with potential threat of minimum wage increase looming in 2016, there are reasons to believe that operating margins might continue to disappoint. If this holds true, the valuations will adjust on the downside.

Second, earnings insights from Factset indicate that more companies have issued negative EPS guidance in for 1Q16 than positive EPS guidance. The detailed report is available here. However, the key point is that earnings might disappoint in 1Q16 and this can trigger negative market sentiments.

Third, China is in a renewed downturn and this is likely to impact several economies globally (primarily commodity producers). With global economic activity likely to remain sluggish in the foreseeable future, earnings can surprise on the downside. The following observation puts things into perspective – According to the Duke’s Fuqua School of Business CFO survey, 59% of the CFOs believe that the slowdown in China is the key risk that might trigger US recession by 4Q16.