Comstock Partners, Inc.May 08, 2008
Are Earnings Estimates Realistic?
Economy Not as Strong as Latest Releases Indicate
In recent years we have consistently discussed P/E ratios and whether we should focus on "operating earnings" or "reported earnings". We continue to argue against focusing on "operating earnings" and now we are questioning the earnings estimates used by the S&P analysts on the site http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS. We also question whether these very aggressive earnings estimates can be achieved in the slowdown or recession in the
In February of this year, our special report, "What is The Real P/E Ratio?", which can be seen on the left side of our home page, discussed this topic at length. The report concludes that "reported earnings" are the only category of earnings that make any sense at all. It also states that the P/E based upon those earnings was approximately 20 on earnings of $73 (last 12 months), while the P/E on the earnings that almost all of Wall Street focuses on, "operating earnings" , was about 14 times estimated 2008 earnings of $98. Since then the actual earnings have been lower than the estimates and the future earnings have been revised downward in both instances. The 2008 earnings were revised downward-reported from $67.90 to $63.60 and operating from $98 to $92.30. With the latest estimates for 2008 the reported earnings P/E is now 22 while the operating P/E is now 15. As you can see in the section Limbo, Limbo on our home page a 15 P/E is reasonable while a 22 P/E is very expensive historically. The market is pretty much unchanged since the special report. The major question we have today is whether the earnings will continue being revised downward and whether the estimates for the rest of 2008 and 2009 are reasonable. Other questions are whether we are actually in a recession, whether the slowdown will spread abroad, and whether the earnings increases that are built into the present estimates make sense.
The S&P 500 estimates for reported and operating earnings are expected to increase about 40% for the second half of 2008 over 2007. This is difficult to swallow in the present environment. The estimates for the year 2009 are up 14% for reported to $72.60 and 21% for operating to $112.16. Since corporate earnings over long periods of time grow at about 6% it looks to us that these estimates are going to be very difficult to achieve. And will be even more difficult to achieve if we are in a recession that may filter-out to our trading partners and continue to spread abroad.
It is true that some of the numbers released over the past week were not as poor as we expected. However, we discussed our problems with the 0.6% increase in the first quarter GDP in the last comment. We also got a better than expected employment reduction last Friday and, believe it or not, we also have a problem with that release. We know, we know, you may think we just make up something every time to give you our slant on these releases, but when you hear about this one we hope you will agree with us. The reduction of 20,000 jobs surprised the economists who were expecting a job loss of about 80,000 (about the same as the last 3 months) and, therefore, drove the market higher. The unusual fact that was buried in the release was the adjustment made by the Labor Department to reflect the "birth-death" statistic. We have criticized this process in many past comments but this one takes the cake!!
The BLS employment result comes from an actual survey of a large number of companies, and not an actual head count. In gathering the employment data the BLS samples about 150,000 businesses and government agencies of the 400,000 that have unemployment insurance tax accounts. The sample accounts for about one-third of all nonfarm payroll workers. In addition, however, the BLS uses something called the ARIMA time series model (also called the net birth/death model) to estimate employment changes resulting from business births and deaths that are not accounted for by other methods. The model reflects the actual residual births and deaths over the last five years. According to the BLS, "The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend.it is likely to remain as the most problematic part of the estimation process." This warning by the BLS in the past about the accuracy of the model was left out of this month's report!
In the month of April the birth-death adjustment was a positive 267,000 and therefore the actual survey came up with a loss 287,000 jobs and, with the adjustment, the total was a negative 20,000. But that is not all-their adjustment included additional jobs in both construction (+ 45,000)and finance (+8,000)!! Do you think it is possible that small finance companies and construction companies were proliferating during this past month? And, now, does knowing how the BLS came up with the negative 20,000 jobs this past month make you more sanguine on the economy or the stock market? We still believe that the housing price decline will effect main street and spill over to commercial real estate and also spread abroad.
Examples from ISI of the contagion spreading overseas are-1. Eurozone PMI retail dropped from 52 to 42 this year. 2. Eurozone real retail sales ex-autos 6 mo. average yr/yr unexpectedly declined in March. 3. An index of