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 U.S., and whether this environment will spread overseas.

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 UK retail sales fell in April to the lowest level in more than two years.  4. UK Manufacturing Production unexpectedly declined in March.  5. German manufacturing orders unexpectedly declined for a fourth month in a row  6. UK Loan approvals reached the lowest since 1999.  7. Mexico consumer confidence dropped from 103 to 98 this year.  8. Housing is weakening in many economies around the world e.g. UK, France, and Spain housing starts and permits are dropping sharply.  9. Eurozone consumer confidence is falling off a cliff following the decline in the U.S.. 

The first quarter GDP was released yesterday and to our surprise showed an expansion of 0.6%.  The stock market, measured by the Dow Jones Industrial Average, immediately rose triple digits and stayed there most of the day. We have stated many times in the recent past that we believed we were in the midst of a recession.  We are still convinced that we are in a recession with the catalyst being home price declines that will make the recession long and/or deep.

Some economists were inspired by the release.  Jared Bernstein, senior economist at Economic Institute of Washington, stated that "the argument that we're not in a recession certainly gets a little more of a boost from this report".  We couldn't wait to dig into the numbers to try to understand why there was expansion albeit at a very slow rate.  We were not surprised to see that the economy would have declined at a 0.2% rate if it were not for a build in inventories.  And although additions to inventory do add to GDP, it is clear that any business where inventories are building does not bode well for the past quarter or the future.  According to the Wall Street Journal this was the first decline in GDP ex-inventories in 16 years.  If inventories and exports (reflecting strength abroad) were excluded, the GDP would have contracted at a 0.4% rate after increasing 1.3% in the 4th quarter of 2007.  Consumer expenditures rose at an annual rate of 1%.  This was the weakest performance since 2001.  Consumer spending fell for a broad range of goods and services that could be considered optional, including cars, auto parts, furniture, food and recreation.  On the other hand, the areas of necessity like health care, housing, and utilities purchases rose. Another report from the Labor Department yesterday showed that workers' compensation, including wages and benefits grew 0.7% in the first quarter.  This was the slowest pace in two years and suggests that the weak labor market is making the employers less generous with their compensation policies.  In fact, Challenger Gray & Christmas just reported that employers announced 290,671 job cuts in 2008 with over 90,000 cuts in April, the highest in 19 months and up 27% more than a year ago.  Unemployment insurance claims also jumped 35,000 to 380,000 while continuing claims exceeded 3,000,000 the highest since April of 2004.  We would not expect a positive employment number tomorrow.

Housing values are so significant to the net worth and psychological well being of the average American that we believe as long as the housing prices continue falling, the spill over into the broad economy will only get worse.  We are talking about the huge sum of $25 TRILLION (at the peak) of asset values melting down. The news on this front just keeps getting worse-in the GDP report yesterday for the first quarter record-high foreclosures dumped more unsold homes on the market, adding to builder's headaches.  Builders slashed spending on housing projects by a whopping 26.7%, on an annualized basis, the most in 27 years.  That was the biggest drag on the economy.  It is hard for us to believe the meltdown of this incredible bubble won't drive the economy into a significant recession accompanied by a bear market in stocks.

 It is also hard to believe that a recession in the U.S., the strongest economy in the world, won't spill over to our trading partners and the rest of the world. We are not just the largest economy but we are the largest by about 3 times the next largest economy.  The U.S. with a GDP of $14 trillion dwarfs Japan at about $5 trillion, China at $3.3 trillion, Germany at $3 trillion, France at $2.2 trillion, and the UK at $2 trillion.

The rally in today's market was based upon the Fed pausing or stopping the interest rate declines which should support the U.S. dollar.  This may be the case, and it is better than the competitive devaluations that we were using as the nations policy over the past eight years(trade weighted dollar declined from 121 to 73).  However, with the tremendous current account and trade deficits with a weak dollar policy, imagine what will happen to these deficits with a strong dollar. There are no easy answers to this mess we are in!!