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 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.

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 (P/E) multiple.  Therefore, based on today’s S&P close of 1698 and consensus estimated 2014 operating earnings of $122, they come up with a reasonable P/E of 13.9 times.  The bears use the same price, but divide it by trailing reported (GAAP) earnings of $90.96, resulting in a P/E of 18.7, at the high end of the range of historical valuations.  In addition, when reported earnings are cyclically smoothed to dampen distortions, the P/E multiple is 19.7.

We have three major problems with the way that the majority determines the value of the market.  First, operating earnings differ significantly from earnings calculated in accordance with “generally accepted accounting principles”, commonly referred to as “GAAP” or reported earnings. Operating earnings start with reported earnings, and then add back a number of expenses considered non-recurring, such as severance pay, plant closings, inventory write-downs, opening and closing of facilities and any other number of expenses that corporate managements may choose to write down.  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 trailing reported earnings, not on operating earnings.  Prior to the last 14 years of sequential bubbles, the 71 year average P/E on this basis was 14.5 (rounded to 15).  Operating earnings, as they exist today, did not even exist until after the mid-1980s, when they came into vogue partly as a means of making earnings look better than they would have been under the accepted rules.  Since operating earnings always exceed reported earnings, often by significant amounts, the P/E on operating earnings has averaged 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 12, rather than the 15 on reported earnings.  In that case, even on 2014 operating earnings of $122, the market would still be overvalued.

Third, but not least, estimates of year-ahead operating earnings are notoriously unreliable.  In the last 28 years, estimates were too high 76% of the time, often by amounts exceeding 20%.  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 operating earnings to determine the value of the market can be extremely hazardous.  In our view, the market is selling at 19.7 times cyclically-smoothed reported earnings, about 31% higher than the historical average of 15, let alone the average multiple of 7-to-10 times seen at the bottom of past bear markets.  At present levels the market is already 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.