One of the bulls’ major reasons for being optimistic on
the stock market is their view that stocks are reasonably valued at 14-to-15
times earnings, well within past norms.
They consistently state this view on financial TV and in print without
ever being challenged by their interviewers.
The far smaller----and shrinking---- number of bears, on the other hand,
contends that the market is substantially overvalued. We believe that the bulls are using a flawed
model that would not have had predictive value in the past, and that the bears
will prove to be correct, as they were in 2000 and 2007.
How can two differing groups look at the same set of
facts and come to such diametrically opposed conclusions? Simply put, the bulls use the current price
of the S&P 500 and divide it by estimated forward-looking operating
earnings to arrive at the current price-to-earnings ratio (P/E). Therefore, based on today’s S&P closing
price of 1854 and consensus estimated 2014 operating earnings of $122, they come
up with a reasonable P/E of 15, or even as low as 13 times if they use the 2015
estimate of $138.
The key words to focus on in the preceding paragraph are “estimated”,
“forward-looking”, and “operating”. The
bears make a similar calculation, but use “actual”, “trailing” and “reported”
earnings----and for good reason. The
problems are as follows. First,
operating earnings usually differ considerably from earnings calculated in
accordance with “generally accepted accounting principles” (GAAP). Operating earnings start with reported
earnings, and then add back a number of expenses considered non-recurring, such
as severance pay, start-ups, inventory write-downs, opening or closing of
facilities and any other number of expenses that corporate managers may choose
at their discretion.
In the past 15 years or so, 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 a normal cost of doing business 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, and not calculated in accordance with
generally accepted accounting principles.
Second, the long-term average P/E ratio of 15 is based on
actual trailing reported earnings, not on estimated forward-looking operating
earnings. Prior to the last 15 years of
sequential bubbles, the 71-year average of
P/E on this basis was 14.5
(rounded by us to 15). Operating earnings
as they are calculated today, did not even exist until after the mid-1980s, when
they began coming into vogue, partly as a means of making earnings look better than
they would under accepted accounting rules.
Since operating earnings always exceed reported earnings, often by
significant amounts, the P/E on operating earnings has averaged about three multiples
below the P/E on reported earnings.
Therefore, it is likely that if operating earnings had a long history,
the average P/E would have been only about 12, rather than the 15 on reported
Third, estimates of year-ahead operating earnings are notoriously
unreliable. In the last 28 years,
estimates were too high about 76% of the time, often by ridiculously high
amounts, particularly prior to turning points in the economic cycle. In May 2008 the estimate for the year was
$89, and eventually came in at $50. At
the same time, the 2009 estimate was as high as $110. The final number was $57.
In sum, the use of forward-looking operating earnings to
determine the current value of the market and to estimate future market levels
can be highly misleading. Currently, the
market is selling at 20.8 times our calculation of cyclically-smoothed reported
earnings of $89, about 39% higher than the historical average of 15. This is higher than at any point in the post-war
period until 1996, and about at the same level reached at the top in 1929.
At present levels the market is discounting a highly optimistic outlook
that leaves it increasingly vulnerable to the serious U.S. and global economic
and political risks that can come to the fore at any time.