As we write this month’s comment the S&P 500 stands at 2,099, 1.33% away from its all-time high of 2,134. So we thought this would be a good time to discuss whether stocks are cheap or expensive relative to historical norms. When investors consider this question they most frequently analyze stock prices relative to past and future earnings. We have the privilege of having written articles on this subject that were published by Barron’s magazine. The articles are titled “What’s the Real P/E Ratio” and “A Simple Calculation” (see attachments).  In the articles we describe the various and often confusing ways that Price/Earnings (P/E) ratios are calculated, and which are used primarily by bulls, and which are used primarily by bears. If you are not familiar with this topic or need a refresher we urge you to open the attachments and read these articles. We continue to subscribe to all that we stated which can be summarized most succinctly as our belief that it is most correct to use GAAP (Generally Accepted Accounting Principles) earnings on a trailing twelve month (TTM) basis when calculating the P/E.

We explain in the attached article that “operating earnings” exclude write offs, while “GAAP reported earnings” include write offs.  That is the main difference, but the difference that is getting much more important as more and more companies resort to using “operating earnings” in order to increase their earnings while bringing down the P/E ratio.  As recently as the early 1990’s GAAP earnings were used exclusively when we started the entrance into the greatest financial mania of all time.  There were so many write offs by companies making unwise investments and then reversing them, that “operating earnings”, grew much faster than the companies using GAAP earnings.  The write offs that had been unusual (using write offs as temporary) became common for more and more companies.

So here is some information based on data from S&P’s website that we believe to be particularly pertinent. With about 97% of the S&P 500 companies having reported first quarter earnings it appears to us that the GAAP number will be $22.43, give or take a little. When added to the previous three quarters we get $87.15 a share in earnings. We should add that Operating Earnings (Non GAAP) look to us to be $99.48, about 14% higher. That differential is slightly higher than when the market peaked in Q3 2007 and also higher than when the market peaked in Q1 2000. Recall that the main difference between Operating and GAAP earnings are that inclusion of extra-ordinary, non-recurring items in GAAP Earnings. Thus to the extent that extra-ordinary items exist, Operating Earnings will always be higher than GAAP Earnings. We also suspect that a good part of this differential (Operating vs. GAAP) is due to the large volume of stock buybacks (many financed by debt and at excessive valuations) that we believe have been a major support for the market. When restricted stock and options that were granted to corporate executives become vested, the “in the money” amount comes directly out of shareholders equity.   GAAP Earnings capture this while Operating Earnings do not.

So given the above numbers of $87.15 in TTM GAAP Earnings versus a 2,099 close the S&P 500 is selling at a 24 multiple. To put that in perspective, if you had a business that you worked hard to build that made $100,000 after taxes and someone walked in off the street and offered you $2.4 million for it you might be inclined to respond “sold to you”! That decision, of course, might be more complicated and largely be a function of expected growth rate, but as we see the numbers, 24 is a historically very high multiple for the stock market in general.

So again from numbers we obtained from S&P here are a few data points that we believe are enlightening. At the end of 1988 the index was 278, the P/E was 11.69. The index “took off” from 306 at Q3 1990 and the P/E was 14.08. Those type of P/E’s might be the kind one would therefore view as on the cheap side, where the market has large potential. On the other side of the coin, for the several quarters preceding the bursting of the “Dot Com Bubble” in 2000 the P/E was in the high 20’s to middle 30’s, the highest that we can document at a top. When the “Housing Bubble” burst, the market dropped from 1527 at end of Q3 2007 and the P/E was 22.19. It had dropped all the way to 1166 (-24%) at end of Q3 2008 and the P/E was 25.38… and THEN the bottom fell out. The point here is that we are in the ballpark of all time rich valuations and while it’s impossible to predict the day a bear market begins, history tells us it is more likely that there is much more downside risk than upside potential. In our opinion, when this period in stock market history is in the record books it will prove to have been a major selling opportunity.

History has many examples of “this time is different“ and we suppose that a big part of the “different” this time is that the economy is finally ready to take off after a “great job” by the Fed in navigating the economy out of a crisis (that began almost 8 years ago!) In other words we finally are about to grow our way out of the low growth/high valuation mess that we’re in. We fully understand what the bulls are saying or more accurately, hoping. We and others call this “The Central Bank Bubble”.  The Fed did its part by stepping on the gas to get us out of the recession caused by the bursting of “The Housing Bubble” (which they and the government were complicit in causing in the first place.)  By keeping its foot on the gas for almost 8 years all it did was inflate financial assets and increase wealth disparity.   We continue to believe that “this time is NOT different” and that in due course “The Central Bank Bubble” will burst.