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 earnings.

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.