Many investors are confused when they hear the vast majority of portfolio managers and strategists in the media say that the stock market is cheap while the minority bears assert that it is significantly overvalued. After all, aren't the two sides looking at the same facts? Well, yes and no. The bears look at trailing cyclically-smoothed reported (GAAP) earnings for the S&P 500, a number that we calculate at about $68 for the year ended 2010. The bulls, on the other hand use estimated 2011 consensus operating earnings of $95. On today's closing price of the index of 1283, we calculate the P/E ratio on $68 at about 19 times, while the bulls divide 1283 by their 2011 estimate and come up with a P/E ratio of 13.5 times. Since both sides are aware that the long-term average P/E ratio is about 15 we see overvaluation where the bulls see undervaluation.
We have three major problems with the way the majority determines the value of the market. First, operating earnings differ significantly from earnings calculated in accordance with "generally accepted accounting principles", commonly referred to as "GAAP" or "reported" earnings. Operating earnings throw back into earnings a number of expenses considered non-recurring such as severance pay, plant closings, inventory write-downs and any number of other expenses that corporations may want to write off. In the past ten or fifteen years 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 normal are called unusual even when these write-offs are taken year after year. In other words, in too many cases what is called operating earnings is pure fiction. That is why we prefer to use earnings calculated in accordance with generally accepted accounting principles.
Second, the long-term average P/E ratio of 15 is based on trailing reported earnings, not operating earnings. Prior to the last dozen years of sequential bubbles the 71-year average P/E on this basis was 14.5 (rounded to 15). Operating earnings as they are used today did not even exist until the mid-80s when they came into vogue partly as a means of making earnings look better than they would have under the accepted rules. 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. For instance in the last 12 years cumulative operating earnings exceeded reported earnings by 23%. This would be enough to reduce a 15 P/E ratio to about 12. In that case the market would be overvalued even on operating earnings.
Third, but not least, estimates of operating earnings a year ahead are notoriously unreliable. In the last 12 years such forecasts have missed the target by an average of 23% in either direction, and some of these misses were laughable. At year-end 2007 the consensus estimate of S&P 500 operating earnings for 2008 was $89. At the end of May 2008, five months into the year, the estimate was still at $89 (see Barron's article May 26, 2008 on home page "What is the Real P/E Ratio?"). Even at the end of October, only two months away from year-end the estimate was at $72. The actual number came in at slightly under $50 just a short while later.
The estimate of operating earnings for 2009 turned out to be just as ludicrous as for 2008. In May 2008 the consensus estimate for 2009 was as high as $110. At year-end 2008, when the extent of the credit crisis was already known for months, the 2009 estimate had only come down to $99. It ended up far lower at $57.
In sum the use of 12-month forward operating earnings to determine the value of the market can be extremely hazardous. In our view the market is selling at about 19 times reported trailing cyclically-smoothed earnings, about 26% higher than the average historical multiple of 15, let alone the average multiple of 7-to-10 seen at the bottom of past secular bear markets. At present levels the market is already discounting an optimistic outlook and is highly vulnerable to any of the serious global problems that can come to the fore at any time.