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 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
