One Overvalued Market: Trailing P/E on “reported” earnings widened to record 140x

Overly Optimistic Consensus Plays Greater Fools' Game Once Again

The crowd is often right except at market turns. After the turn, the crowd tends to hold on until most previous gains vanish. In a secular bull market, such optimism works out acceptably well. In a secular bear market, rampant optimism is severely punished.

David Rosenberg is discussing the overly-optimistic consensus in a Special Report: A “V”-Shaped Recovery.

One Overvalued Market

There has been plenty of debate over whether equities are overvalued or not, and certainly we would assume that many investors know where we stand on the topic.

On an operating (“scrubbed”) basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x.

While we will not belabour the point, when all the write-downs are included, the trailing P/E on “reported” earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble.





It is interesting to hear market bulls talk about how distorted it is to be using trailing multiples that include ‘recession earnings’ (even though using ‘forward’ earnings means relying on consensus forecasts on the future and these are rarely, if ever, correct). It is also interesting that the last time the multiple was this high was back in March 2002, again after a huge countertrend rally that deployed ‘recession earnings’ from the 2001 downturn. If memory serves us correctly, this was right around the time that the bear market rally started to roll over and in fact, six months later, the S&P 500 was hitting new lows and 34% lower than it was when the multiple had expanded to … today’s level!

Even On A Forward Basis, The Market Is Overvalued

Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which, of course, will never occur again.

The consensus is usually overly-optimistic, which is why so many analysts love to do their analysis on “forward” earnings since the market almost always looks “attractively priced” on that basis. The reality is that the forward P/E multiple is now at 16.2x after bottoming at 11.7x at the market lows. The multiple has not been this high since February 2005 when the economic expansion was already nearly four-years old! Today’s stock market, on this basis, is now being priced as if we are late in the cycle — forget this mid-cycle valuation stuff.

At the October 2007 market highs, the forward P/E multiple was 15x compared to 16.2x today, so you can understand why it is that:
1. We think investors are paying too high a price to participate, and;
2. We think that valuations are closer to levels more befitting an economy in its more mature stages of expansion than in its infancy.

Valuation may not be the best timing device, but it still pays to know whether you are getting into the market at acceptable prices. If the S&P 500 was in a 700-750 range, de facto pricing in zero to 1% GDP growth, we would certainly be interested in boosting our allocations towards equities. But at 1,070 and over 4% GDP growth effectively being discounted, we will be spectators as opposed to participants, understanding that the key to success is to NOT buy at the peaks. So the strategy is to sit on the sidelines, be selective in our equity choices, and wait for the correction to come or for the fundamentals to catch up with this overvalued, overbought, overextended market. Remember, the reason why the tortoise won the race was because the hare got tired.

S&P 500 Is Way Ahead Of Itself

What do we know from 60 years of historical data? We know that the market typically faces serious valuation constraints once it breaches the 25x P/E multiple threshold. The average total return a year out for the S&P 500 is -0.3% and the median is -6.2%. The total return is negative a year later 60% of the time, so when we say that there is too much growth and too much risk embedded in the equity market right now, we like to think that we have history on our side.

There is much more in the article so it's well worth a look.

This rally has the same look and feel as the 1930 DOW rally. Is there more left? No one knows. What we do know is that on average it does not pay to play for it.

Moreover, forward earning estimates are ridiculously high and loan loss reserves on commercial real estate, credit cards, walk-aways, foreclosures, etc. are grossly inadequate.



ALLL stands for allowances for loan and lease losses.

Allowances for loan losses will decrease as charge offs increase. However, the above charts are in relation to non-performing loans.

Because provisions for loan losses are a direct hit to earnings, and because allowances are at ridiculously low levels, bank earnings have been wildly over-stated. That is one indication of optimistic forward earnings.

Another indication of optimistic forward earnings is that banks have not yet gone to a mark-to-market model on assets. Factor both together and financial earning estimates are wildly optimist.

Kroger, Walmart, Costco Blame Deflation For Poor Earnings

In regards to non-financials, bear in mind that Kroger, Walmart, Costco are blaming deflation for a drop in earnings. Please see Deflation Threat? What Deflation Threat? for an analysis.

Certainly that is an indication that forward estimates are too high. Moreover, with the unemployment rate close to 10% and expected to rise for another 12-18 months, in light of the fact that consumer spending is 70% of the economy, bulls are extremely hard pressed to state where this miraculous growth in earnings will come from.

The only possible answer, and one typically only presented by the gold bulls and hyperinflationists is a complete collapse of the US dollar. While possible, I doubt it at this time.

For more on the US dollar vs. the Yuan, please see Competitive Currency Debasement - A Look at Rampant Monetary Expansion In China.

For more on global imbalances and the US dollar vs. other currencies please see Gold And The Watched Pot Theory.

Greater Fools' Game In Progress

What this all boils down to is the overly-optimistic crowd is playing the Greater Fools' Game once again. Some players realize it. Most don't. One thing is for certain, not everyone can leave the Greater Fool's Train at the same time once it starts heading in reverse.


http://globaleconomicanalysis.blogspot.com/2009/10/overly-optimistic-consensus-plays.html

 

Reality Check:

1. currently inflation in the overall US economy (not core) is running at 5%.

2. Manipulation, hype and sentiment, inflation, dividends and earning growth are drivers of the market. The first three factors are most important in the short run. Inflation is the most important driver in the long run.

3. The market, in the short run, tends to be disconnected with underlying corporations. This is particularly true for non-dividend stocks.

3. The market is currently inflated beyond the inflation in the general economy.

4. Eventually, inflation of earnings through price increases will resemble the market's inflation.

5. There will be a market correction at a future date that will bring it closer to reflecting the inflation in the real economy. Any resemblance of the stock market on a day to day basis to the real economy is purely coincidental..

The lesson here is that if one is interested in making money by short term trading in markets, one should not pay much attention to economic reality.

 

Here's another view of the P/E of the market, suggesting it is only 15.6, which, in my opinion, carries much more weight than the old fashioned way of calculating it considering the extraordinary times.

"A quick indication of whether or not the S&P 500 index is fairly valued is normally available by simply looking at its P/E ratio. Unfortunately , at this time it is not clear what the P/E ratios on the S&P 500 is. As of August 5, the S&P 500 closed at 1003 and had a P/E ratio (based on actual reported earnings in the past year) of 130. This is extremely high. Therefore the quick indication is that the S&P 500 index is extraordinarily over-valued at this time at 1003. However this would be jumping to conclusions. Earnings on the S&P 500 index have recently been depressed by huge losses at a few major companies and may not represent the normal expected earnings level. Meanwhile the forecast operating P/E on the S&P 500 from Standard and Poors itself, based on eliminating all unusual gains and losses and based on the summation of such forecasts by individual companies is relatively low at 15.6 indicating that the index is reasonably valued."

http://www.investorsfriend.com/S and P 500 index valuation.htm

 

The last time the dow passed 10,000 in 1999 the dot com bubble pushed it along the way in that time of the bull market.


The 2nd jump above 10,000 the help of historical low interest rates, excess liquidity, great leverage and a housing bubble led to new highs in all indexes October 2007 before reality kicked in.

Today marked the third time above dow 10,000, it has crossed 10,000 around 25 times but the last 2 times it pushed above 10,000 and stayed there for quite sometime. What can push the market higher besides a falling dollar and unlimited amounts of monopoly money???

I don't think it matters how overvalued the market it is as long as their is free money to push into every corner of the market from here on in up seems the only way. However everyone knows what happens after bubbles pop and all the free money stops.

 

P/E mults are always done on a forward basis. Then, it's a much more reasonable 16, A point or two higher than I would like, but not far off from historical averages.

 

BLSH-

Serious question, not flaming-

We all know the market is being manipulated up with free fed money, accounting changes, low volume, cooked books, shadow inventory, collapsing dollar, etc, etc, etc.

At what point do you throw in the towel on your relentless doom and gloom threads and just realize that the market doesn't give a shit?

 

Dot com Bubble

Commercial Real Estate Bubble

Housing Bubble

Treasury Bubble

Commodity Bubble

in the making right now is the



BEN bernanke bubble

 

Clubber-


Serious question, not flaming-

Would you admit the economy is rubbish in most parts, and more importantly, that the risk/reward profile at these levels for investors and traders is incredibly less attractive than in March?

Would you consider it possible (let alone likely) that unlike times past, retail crowd might get sucked in to the markets while the economy is very anemic, and that an incredibly tepid recovery (if one at all, short or intermediate term) is underway?

If so, would you concede that current valuations are extraordinarily rich?

 

BLSH,

Answers to your questions-

I think the economy is dogshit in the rust belt, California, Nevada, and Arizona. In the NYC area (going by what I've seen) everything returned back to "almost normal" around the spring/early summer.

I think the risk/reward is awful at these levels, but I've also thought that for the last 100+ S&P points.

I think 90% of retail are a bunch of stupid asswipes who watch CNBC and Jim Cramer for investing advice, so yes I think they will get sucked into this manipulated Fed induced rally.

I agree that valuations are beyond rich (but like I said, I thought that at S&P 950 too).
--------------------------

I totally agree with you that things are way worse than the mainstream media will ever admit to. If not for the Mark to Market change and a trillion dollar printing spree, I think we could have easily gone below S&P 400, maybe even 300.

That being said, the Fed, Goldman, and other insiders will manipulate this market up for as long as possible.
Wall st. needs to get big bonuses this year since 2007 and 2008 were very light or non existant.

I just feel bad for the average guy reading the newspapers thinking "the recession is over, everything is fine". There will be at least one more mega plunge of this market sometime in 2010/early 2011 and they will all get screwed again.

Until then, just buy with both hands and be prepared to unload at the first sign of weakness.

 

We agree for the most part, then. I'd just point out that the New York region seems to have been narrowed in the sense that even with a 50% uptick in equity markets since the March lows, there are fewer people working in the financial sector pulling down the big bucks, and many New Yorkers lost a boatload of wealth in asset depreciation, regardless of regaining some value in equities (assuming they were invested appropriately to take advantage of this bounce).

But you live there, I don't, and I rarely dismiss the value of eyes on the ground as superior to long distance assessments (although I do have a cousin who lives on the upper east side of Manhattan, who is married to attorney who is an equity partner at a large law firm, and she tells me that things have gotten relatively bad even in their area from an asset depreciation basis).

Thanks.