The latest weekly commentary by Comstock Partners.
We stated in the 4th of July holiday comment that we would discuss valuations in the "special report" we wrote last week. As it turned out the "special report" got too bogged down in the discussion of why the private debt in our country would have to be deleveraged before a significant recovery could take place. We encourage you to read it.
This comment will now address why there is so much controversy about valuations in the stock market presently. The bulls are constantly exclaiming in the financial press and financial TV why investors must buy equities due to these "fantastic valuations". We asked our viewers to prepare for this comment by taking a look at the section on our home page titled "Limbo, Limbo, How Low Can it Go?" There you will find many different metrics that show the historical valuations and where the stock market sold at the peaks and troughs over many years. All these charts were produced by Ned Davis Research, which we consider the best data source available.
We believe after studying the charts mentioned above you will find that none of the most popular metrics will show the stock market to be inexpensive. The only way the main valuation metric (P/E Ratios) could show the market to be cheap is to replace the age old "reported earnings" (Generally Accepted Accounting Principles-GAAP) with "operating earnings".
The pundits are using forward looking "operating earnings" in order to reach for their estimates of 10 to 12 times earnings. "Operating Earnings" which exclude "write-offs", make no sense whatsoever, and only came into existence in the mid 1980s in order to make the market look undervalued. We advised you to look at the articles written by us and published in Barron’s on our home page (Comstock in the News). The first was in May of 2003 titled "A Simple Calculation", and the second titled "What’s the Real P/E Ratio?" written in May 2008. We just reread the 2008 article and found some interesting statistics we used back then, and until now, didn’t recall just how far off the earnings estimates were.
This is what we stated in the article back in May 2008, "Look at the numbers. Reported earnings for the S&P 500 for 2007 were just over $66. The operating earnings for 2007 were $84.54. The estimated numbers for 2008 are about $69 for reported earnings and about $90 for operating earnings. By the way, these estimates have just recently been revised downward drastically, due to the slowdown in the U.S. economy." Imagine what they were before they were revised downward drastically. The actual numbers came in at $14.88 for reported earnings vs. the estimate of $69, and $49.51 for operating earnings vs. the estimate of $90 (see actual earnings in the attached chart–Sorry-the chart will be posted tomorrow). This means that with just 7 months to go in 2008 the earnings were off the $69 estimate by $54, and off the $90 estimate by $40. This goes to show how absurd it was and still is to use forward earnings-and imagine if we used the estimates before they were revised downward drastically. Numerous articles have been published which show that forward estimated earnings are not reliable.
The earnings estimates for the year 2010 are about $82 for operating and $67.35 for reported earnings. The earnings estimates for 2011 are $95 for operating, and $78 for reported earnings. As bad as it is to use forward earnings, the really insane part of these estimates is that virtually all of "Wall Street" is using Operating earnings that were not even in existence before the mid 1980s. Even more outrageous is the fact that these earnings exclude "write-offs" even if the write-offs are recurring and disregard the GAAP earnings (reported earnings) which were the only earnings ever used before the mid 1980s (and which became more popular each year as it became harder to make stocks look undervalued-especially during the dot.com bubble).
If you break down these earnings estimates by the quarter or half year, you will find that the estimates are higher for the second half of this year than the first and clearly higher by about 15% in 2011. We find this to be curious since it seems to us that the recovery is running out of steam. The main ingredients for virtually any upswing in the economy are dependent upon 1. Employment 2. Consumer Spending 3. Housing 4. Increase in Exports, and 5. Restocking of Inventory. Usually these ingredients need easy money or some form of inflation. Despite low interest rates banks are reluctant to loan money to small businesses and individuals. These ingredients needed to stimulate the economy have all either rolled over or never really got started (Housing-see 6/10/10 "The Dire Outlook for Housing"). Retail sales were just released and were disappointing for the second month in a row after a false start from the stimulus package. Employment continues to disappoint and the rebuilding of inventory has come to a screeching halt. The trade deficit has just recently gotten worse and that speaks volumes about our ability to export goods and services.
The worst part of the ingredients that produce an economic rebound is the fact that deflation is permeating the whole system. The Fed was worried about deflation back in 2003 and talked about it constantly. Well now, according to the Federal Reserve Bank of Cleveland, the median Consumer Price Index was virtually unchanged at 0.0% in May, while the CPI was down 0.1% in April and down 0.2% in May. The PPI released today was down 0.5% in June vs. down 0.3% in May. In 2003 the median CPI from Cleveland was up about 1.5% and the CPI was up 2.3% during all of the Feds ranting about deflation and how they would make sure it will not occur in this country. They were able to drop rates to 1% and keep them there for a year, which was the main impetus that drove housing and stocks into a bubble, comparable to the dot.com bubble, from 2003 to 2007. We suspect strongly that the recent easy policy will not produce a third bubble. It takes a while for investors to learn from past mistakes and there is no way to start another bubble in the near future.
It sure doesn’t seem that the economy has much going for it, and if that is the case, it is hard to believe that the earnings will be higher in the second half than the first (which is presently the estimate), and really hard to believe that they will increase by 15% next year (which is also the estimate). If we use the reported earnings estimate of $67.35 (which we don’t believe) you get a P/E of 16.2, if you use the estimate of next year of $77.64 (which we really don’t believe) the P/E works out to just over 14. All of these P/E ratios on reported earnings are above the average for forward earnings and do not reflect an undervalued market.
Our favorite means of determining a fair valuation is to smooth the reported earnings over a 9 year period of time by taking the 9 year average and grow the average for 4.5 years (one half the 9 years) at 6% (where earnings have grown historically) to arrive at the $64 of smoothed earnings. Using the smoothed earnings of $64 you arrive at the overvalued level of 17 times. We also believe that this market will not bottom out until it reaches 10 times or lower the smoothed earnings. Although this may sound implausible, we note that the S&P 500 sold at a P/E of 10 or under smoothed earnings in 17 of the past 60 years.