There was sort of a debate recently in the Wall Street Journal about whether the first quarter earnings of the S&P 500 would achieve the current estimates of $13 per share for "operating earnings" (bottom up). We are sure that you know what our criticism of this number will be, and we will not give up discussing this until most of Wall Street starts using a more realistic measurement. Naturally, we believe they should be debating what the "reported earnings" will be in the first quarter of this year and not "operating earnings".
First of all (regular viewers will find this boring), why would anyone continue using the earnings that "exclude write-offs" (these are called "operating earnings"), when they can use the only earnings that have a long history ---referred to as "reported earnings". These are the Generally Accepted Accounting Principals (GAAP), and the earnings that were primarily used for the past 90 years.
Actually, both of these two categories of earnings are misnomers. Why would anyone call earnings that exclude "write-offs" as "operating"? Operating earnings, as we have learned in school (even high-school) are revenues minus cost of goods sold. Then the other expenses like selling, general, and administrative expenses, as well as others such as depreciation are subtracted to finally achieve the net earnings. The other misnomer-"reported earnings" is even more ridiculous. Doesn't every company report their earnings? Why would anyone classify the only earnings that comply with GAAP, that have a long history, and that include "write-offs" as "reported earnings"?
The "operating earnings" for last year were $50 for the S&P 500 and $15 for "reported earnings". This means that the difference of $35 was all "write-offs" that were not counted in the "operating earnings". Is it possible that the "operating earnings" that only came into existence in the late 1980s to justify the market's overvaluation is still the main earnings used by Wall Street?
OK, OK, the rant is over-now let's discuss what the earnings could be in the first quarter. This comment was written last week (but not posted due to the holidays) so there have been changes made in the estimates just yesterday. You will be able to check the earnings and latest earnings estimates by clicking on this link-- http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS .
We don't think the $13 of "operating earnings" (lowered just yesterday to $12.29) will hold up since there have been so many earnings warnings. The "operating earnings" were negative for the fourth quarter of 2008. This is the first time the S&P 500 had negative earnings in history, although small (-9 cents), and we don't expect them to reach the $13 estimated for the first quarter.
The earnings that COUNT are now expected to come in at $8.75 (yesterday reduced to $7.32) for the first quarter and that comes off of a loss of ($23.25) in the last quarter of 2008. That would be down from the first quarter of 2008 of $15.54 and may well be achieved. Nevertheless, we expect the "reported earnings" for all of 2009 to come in with a $20 handle and this means the P/E is very expensive for the full year. Because we believe the "reported earnings" of this year and last (about $15) are "outliers" we have been smoothing the earnings over a nine year period. This smoothing will keep the handle in the $50s. We still believe the secular bear market we are presently experiencing will not bottom until it gets down to about 10 times our smoothed "reported earnings", and that is why we expect the S&P 500 low of 666 to be broken and the market to eventually reach a bottom somewhere below the 600 area.
Other valuation measures support the view that the market rally will not continue (or at least not rise above the next resistance of 878 or at best the January high of 944). The dividend yield of about 3.5% is right in the middle of cheap and expensive, but if you take into consideration the dividend cuts (that are now at a record) the dividend yield drops to 2.6% according to Howard Silverblatt at S&P. This is considered very expensive.
Add these two valuation parameters together (you could also add price to cash flows and price to sales-see Limbo Limbo on our home page) and we believe this market rally does not have much further to go.