Talking Out of Their You-Know-Whats

In "Current Market Boom 'Can't Be Trusted,' Robert Shiller Says," posted earlier this week at Yahoo! Finance's Tech Ticker, the author of the bestselling publication that essentially called the top of the dot-com era bull market raised some concerns about the headiness in share prices:

Are we on track for a repeat of irrational exuberance?

With the stock market up more than 50% since March and the Standard & Poor's Case/Shiller Index on the rise for the last three months, it's a worry, says Yale Professor Robert Shiller. "Somehow we got into this really speculative mentality and I don't think we're out of it yet."

Given the current economic environment, "these booms [in the housing and stock markets] that we're seeing now can't be trusted to continue," Shiller tells Tech Ticker in the accompanying video [at the TT site], taped at last week's Buttonwood Gathering.

The author of Irrational Exuberance and Animal Spirits characterizes the stock market rally as an "amazing rebound" without much historic precedence, "you have to go back to the Great Depression to see such a turnaround in the stock market."

According to his cyclically adjusted P/E valuation model - stock price divided by average 10-year earnings - stocks are overvalued today, but "not massively overvalued."

The market's rebound isn't likely to be derailed by valuation in the short term, Shiller says, but if one looks to the classic bear market rally of 1933-1937 as a guide, stocks may eventually crater as they did then.

That said, some long-time market watchers might take issue with the professor's assertion that stocks aren't priced at historical extremes. In its latest weekly commentary, "Stock Market Significantly Overvalued," Comstock Partners argues that, compared to where they have traded in years gone by, equities are anything but cheap:

In recent weeks we have been pointing to the unsustainability of the economic recovery as a key reason for doubting the surge in stocks since the March lows.  In this comment we will show why we believe the market is also considerably overvalued on the basis of earnings.

The media, both in print and on TV, rather consistently maintain that the market is either cheap or, at worst, reasonably valued.  With consensus 2010 S&P 500 bottom-up operating earnings currently estimated at about $74 (up 35% from 2009) the P/E ratio comes out at 14.8, a valuation that sounds reasonable at first glance. There are, however, a few problems with that logic. The long-term history of P/E ratios on the S&P 500 is based on actual reported trailing (GAAP) earnings rather than forwardly-estimated operating earnings. (As most of you know GAAP stands for generally accepted accounting principles and includes write-offs whereas operating earnings exclude write-offs.) Reported earnings are audited numbers, while write-offs are whatever companies say they are. In the past decade companies have gotten a lot more creative about what items they can write off and now a large number of expenses that used to be considered as normal expenses are now called unusual even though these write-offs are taken year after year. In other words, in too many cases what is called operating earnings is really pure fiction.

The average long-term P/E ratio of trailing reported earnings over the 73 years prior to the stock market bubbles of the last decade was 14.5 (round to 15).  Operating earnings did not even exist until the mid 80s.  Since operating earnings almost always exceed reported earnings, often by significant amounts, even if we had such results going back further in history the average P/E on them would be much lower than for reported earnings. Moreover, if we used forward rather than trailing earnings, the long-term P/E ratio would be even lower, most likely somewhere around 11.  In this case even a 14 or 15 P/E ratio on forward operating earnings would indicate substantial overvaluation.

Given these considerations, where do we stand in terms of valuation at today's closing S&P 500 of 1092 compared to a historical average P/E of 15? On estimated 2009 reported earnings of $40, the P/E is 27, while the P/E on estimated 2010 earnings of $46 is 24. Even on estimated 2009 operating earnings of $55, the P/E is an overvalued 20.

Some argue that calculating the P/E on earnings that may be unduly depressed distorts the true value, and they do have a point.  Therefore, in both strong and weak earnings environments we have long used a method to smooth earnings over an entire cycle or more.  On this basis we come up with a smoothed trendline reported earnings number of $60, resulting in a P/E ratio of 18.2, still well over the historic norm of 15. The conclusion: anyway we look at it, the market is overvalued.

Yet even Comstock Partners assessment sounds somewhat tame if you contrast it with the opinions expressed by one old market hand, an independent economic advisor who for many years toiled at the fund management arm of a venerable British financial institution called S.G. Warburg & Co., in an FT Alphaville post entitled "The US Stock Market Is Overvalued by 40%":

Andrew Smithers, of London-based research house Smithers & Co, is not a man who has any truck with nonsense. Particularly when it comes from the mouths of stockbrokers.

In his latest report, The US Stock Market: Value and Nonsense About It, he takes to task those who claim US equities are still cheap:

As we have remarked before, valid approaches to value are disliked by many practitioners as they get in the way of business. As is inherently likely, and as a glance at Chart 1 will confirm, the stock market has been underpriced around 50% of the time. Those who sell shares would rather it were cheap 100% of the time and therefore prefer invalid metrics. The ones used vary from time to time, as those employed are restricted to those which currently give the desired answer that “stocks are cheap”.

Smithers says there are only two ‘valid’ ways to value the market. One is by using a cyclically adjusted PE ratio and the other by using the Q ratio, which compares the market capitalisation of companies with their net worth,  adjusted to current prices.
Whichever technique is used, the answer is the same: the US stock market is overvalued by around 40%.

Smithers explains:

As the valid measures of the US market show that it is currently around 40% overvalued, some ingenuity is needed to claim otherwise. The EPS for the past 12 months on the S&P 500 is $7.51 so, with the index at 1071, it is selling at a trailing PE of 142. This is far higher than it has ever been before, as the previous end month record is a PE of 47. But current multiples are no guide to value; when depressed, or elevated, they need to be adjusted to their cyclical norm.

This is how the cyclically adjusted PE (”CAPE”) is calculated and when its current value is compared with long-term average, using the geometric means of EPS and cyclically adjusted PEs,6 it shows that the market is 37.7% overpriced using 10 years of earnings’ data and 45% if 20 years are used. This method is therefore of no use to those who sell shares, or have made faulty claims about value in the past. The following are among the most common approaches to circumventing the problem this presents. Some produce relatively small distortions, but these can amount to a substantial degree of misinformation when combined.

Valuation isn't all that matters, of course, when it comes to which way share prices will go. Nonetheless, those bulls who cite valuation as a reason to be positive on stocks would seem to be talking out of their you-know-whats.

Comments

[W.C. Varones]

#1 reason to be bullish: because share prices are denominated in Bernanke dollars!

[just a fan]

Financial Armageddon, February 26, 2008:

'Bracing for Well Over 100 Bank Failures'

( http://www.financialarmageddon.com/2008/02/bracing-for-wel.html )

106 failures just in 2009 so far (not counting 2008).

[roger]

reading the European press,in less than 2years expect
meltdown of the US $, ,the $ is now seen more as a
sham than a safe heaven,funny money is no more accepted
for accumulation by central banks all over the world.
Bloomberg.com sept. 15/09,Europe is now wealthier than US.
The Euro is now fast becoming an alternative to the US $

[Mark G.]

Go long and go loud!

[mthomas]

I think that today's action in the dollar is the start of an intermediate trend rally, given how bearish most people are on the dollar. Right now being short the dollar is very overcrowded, and while I'm bearish on it too in the long term, I think it is due for a rally. And in the process I expect the stock market to decline considerably, like it did in the 2nd half of 2008. But this time I expect gold to hold up rather well, because the only reason the dollar is strengthening is due to deleveraging and an unsustainable financial system with too much debt. I think the gold price can actually rise with a stronger dollar because it will signal the loss of confidence in the system and peoples' desire for a return to a sound form on money.

The market looks like it's had enough of the green shoots, and maybe it's even viewing them now as a reason for the Fed to tighten monetary policy, which would be negative for the economy. I therefore still feel that for long term investors a better portfolio allocation is in cash and gold. I recently read some very interesting articles on these topics at http://www.goldalert.com/gold_news.php, which discuss the relationship between the dollar, the gold price, and gold mining companies given the Federal Reserve's monetary policies. I thought the article titled "Gold Price and Negative Nominal Interest Rates" was particularly useful for investors to read to get a better sense of the relationship between these asset classes given the volatility and uncertainty in our global financial system.