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The Problem With Forward P/Es

Tyler Durden's picture




 

Submitted by Lance Roberts of STA Wealth Management,

In a recent note by Jeff Saut at Raymond James, he noted that valuations are cheap based on forward earnings estimates.  He is what he says:

"That said, valuations are not particularly onerous with the P/E ratio for the S&P 500 (SPX/1841.13) currently trading around 15.2x this year’s bottom-up estimate of roughly $121 per share. Moreover, if next year’s estimates are anywhere near the mark of $137, the SPX is being valued at a mere 13.4x earnings."

As a reminder, it is important to remember that when discussing valuations, particularly regarding historic over/under valuation, it is ALWAYS based on trailing REPORTED earnings.  This is what is actually sitting on the bottom line of corporate income statements versus operating earnings, which is "what I would have earned if XYZ hadn't happened."  

Beginning in the late 90's, as the Wall Street casino opened its doors to the mass retail public, use of forward operating earning estimates to justify extremely overvalued markets came into vogue.  However, the problem with forward operating earning estimates is that they are historically wrong by an average of 33%.  The chart below, courtesy of Ed Yardeni, shows this clearly.

Yardeni-Forward-Estimates

Let me give you a real time example of what I mean.  At the beginning of the year, the value of the S&P 500 was roughly 1850, which is about where at the end of last week.  In January, forward operating earnings for 2014 was expected to be $121.45 per share.  This gave the S&P 500 a P/FE (forward earnings) ratio of 15.23x.

Already forward operating earnings estimates have been reduced to $120.34 for 2014.  If we use the same price level as in January - the P/FE ratio has already climbed 15.37x.

Let's take this exercise one step further and consider the historical overstatement average of 33%.  However, let's be generous and assume that estimates are only overstated by just 15%.  Currently, S&P is estimating that earnings for the broad market index will be, as stated above, $120.34 per share in 2014 but will rise by 14% in 2015 to $137.36 per share.  If we reduce both of these numbers by just 15% to account for overly optimistic assumptions, then the undervaluation story becomes much less evident.  Assuming that the price of the market remains constant the current P/FE ratios rise to 18.08x for 2014 and 15.84x for 2015.  

Of course, it is all just fun with numbers and, as I stated yesterday, this there are only three types of lies:

"Lies, Damned Lies and Statistics."

With the continued changes to accounting rules, repeal of FASB rule 157, and the ongoing torturing of income statements by corporations over the last 25 years in particular, the truth between real and artificial earnings per share has grown ever wider.  As I stated recently in "50% Profit Growth:"

"The sustainability of corporate profits is dependent on two primary factors; sustained revenue growth and cost controls.  From each dollar of sales is subtracted the operating costs of the business to achieve net profitability.  The chart below shows the percentage change of sales, what happens at the top line of the income statement, as compared to actual earnings (reported and operating) growth."

S&P-500-AccountingMagic-030414

"Since 2000, each dollar of gross sales has been increased into more than $1 in operating and reported profits through financial engineering and cost suppression.  The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth.  This has been achieved by increases in productivity, technology and offshoring of labor.  However, it is important to note that benefits from such actions are finite."

This is why trailing reported earnings is the only "honest" way to approach valuing the markets.  Bill Hester recently wrote a very good note in this regard in response to critics of Shiller's CAPE (cyclically-adjusted price/earnings) ratio which smoothes trailing reported earnings.

"More recently the ratio has undergone an attack from some widely-followed analysts, questioning its validity and offering up attempts to adjust the ratio. This may be a reaction to its new-found notoriety, but more likely it’s because the CAPE is suggesting that US stocks are significantly overvalued.  All of the adjustments analysts have made so far imply that stocks are less overvalued than the traditional CAPE would suggest."

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns. But we decided to come to the aid of the CAPE ratio in this case because a few errors have slipped into the debate, and it’s important for investors who have previously relied on this ratio to understand these errors so they can judge the valuation metric fairly.  Importantly, the primary error that is being made is not even the fault of those making the arguments against the CAPE ratio. The fault lies at the feet of a misleading data series."

Hussman-Cape-031914

If I want to justify selling you an overvalued mutual fund or equity, then I certainly would try to find ways to discount measures which suggest investments made at current levels will likely have low to negative future returns.  However, as a money manager for individuals in retirement, my bigger concern is protecting investment capital first.  (Note: that statement does not mean that I am currently in cash, we are fully invested at the current time.  However, we are not naive about the risks to our holdings.)

The following chart shows Tobin's "Q" ratio and Robert Shillers "Cyclically Adjusted P/E (CAPE)" ratio versus the S&P 500. James Tobin of Yale University, Nobel laureate in economics, hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets.  Currently, the CAPE is at 25.41x, and the Q-ratio is at 1.01.  

Tobins-Q-Shiller-PE-031914

Both of these measures are currently at levels that suggest that forward stock market returns are likely to be in the low to single digits over the next decade.  However, it is always at the point of peak valuations where the search for creative justification begins. Unfortunately, it has never "been different this time."

Lastly, with corporate profits at record levels relative to economic growth, it is likely that the current robust expectations for continued double digit margin expansions will likely turn out to be somewhat disappointing. 

Profit-Growth-GNP-ForwardGrowth-030314

As we know repeatedly from history, extrapolated projections rarely happen.  Therefore, when analysts value the market as if current profits are representative of an indefinite future, they have likely insured investors will receive a very rude awakening at some point in the future.

There is mounting evidence, from valuations being paid in M&A deals, junk bond yields, margin debt and price extensions from long term means, "exuberance" is once again returning to the financial markets.  Again, as I stated previously, my firm remains fully invested in the markets at the current time.  I write this article, not from a position of being "bearish" as all such commentary tends to be classified, but from a position of being aware of the "risk" that could potentially damage long term returns to my clients.  It is always interesting that, following two major bear markets, investors have forgotten that it was these very same analysts that had them buying into the market peaks previously.

 

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Wed, 03/19/2014 - 19:49 | 4570026 ebworthen
ebworthen's picture

I just hope you get the signal to get out before the next black swan.

They need to crash it again to clear the little people's chips off the table and keep them scrubbing toilets and making the lobster bisque.

Perpetual bubble economy; with the dwindling middle class running on the hamster wheels thinking they are getting somewhere, chewing on those "retirement" statements.

Wed, 03/19/2014 - 19:59 | 4570063 Winston Churchill
Winston Churchill's picture

Those Retiremnt statements are issued solely for the sadistic amusement of the PTB.

Wed, 03/19/2014 - 20:18 | 4570121 disabledvet
disabledvet's picture

let me explain investing to you in a single sentence: "you don't double down on wrong."

and of course this place is a case study in that. right now in particular actually.
"Tylers Durden never saw a losing trade they didn't want to lose more on."
That's why the "Goldman Sachs" always gives out a: false advice b: bad advice and c: false/bad advice.

They're constantly "doubling down on wrong."
Sure...having a huge bubble doesn't hurt...but you have to overlay that with "leverage" and "direction." The only reason to "double down/advocate the double down" is because you are not only directionaly wrong (short) but "levered to the moon too!"...and you THINK "just around the corner the market will move in your favor."

Being short does not qualify one for the "too big to fail grant hypothesis" as well.
In short "don't double down on wrong."

i am not a trader but those that are have told me this is the very definition of ROOKIE MISTAKE.
http://www.youtube.com/watch?v=Cr1MvzAr26E

again...i do not trade..but when Jim Cramer says "stop trading" i think that's the best advice ever. 3:00 PM he says? Or is it 3:30 PM...
and of course "losses on the short side are infinity."
on the long end "i can only lose what i put in plus leverage if any." in theory if the dividends are solid you can make far more of your original investment just in income than you ever did by putting principle down.

God forbid "if you're short and the other guy decides to start The War." Now you're not only buying back your losing (short covering) position but taking an ownership stake (the ownership stake?) in a company that really might be the total dud you said it was all along "and giving all the money to the longs" (who are now selling) at the same time. since by definition "we are all market timers".........

Wed, 03/19/2014 - 19:59 | 4570062 TideFighter
TideFighter's picture

PE has been removed from educational curriculums years ago; it's just not needed.

Wed, 03/19/2014 - 20:11 | 4570075 khakuda
khakuda's picture

Corporate profit margins are well above the long term average, primaily as a result of low interest rates and tax rates (some of which is because of offshoring and some from tax loss carry forwards from the collapse).  S&P earnings would be 25% lower if margins were normal, so your $121 in earnings this year would drop into the $90s, making the market about 20x earnings and not cheap.

Wed, 03/19/2014 - 20:14 | 4570099 LetThemEatRand
LetThemEatRand's picture

Offshoring is a huge component, and in my view the most dangerous.  They have gutted the middle class in the West for short-term gain.   You cannot sustain a business in the long-term selling to people who are buying today on credit (including student loans that pay for many of the gadgets) or savings.  The Western middle class sustained itself with home equity loans in the early 2000's, and it is now selling off what's left and/or borrowing against what is left.  In the East, the middle class is a shadow of the prior Western version.  That model is doomed to failure.  By design.

Wed, 03/19/2014 - 20:20 | 4570125 khakuda
khakuda's picture

Couldn't agree more.  It is why the Fed's path is SO destructive to real growth.  They are not letting the cost of living to drop to affordable levels - has there not been inflation in healthcare, college tuition, house rents or gasoline the past decade or so???  Has it not surpassed people's ability to pay as jobs left the country???  Have they been hiding under an academic rock?  There is inflation in taxes, too, we just haven't gotten the bill yet, but it is there in the form of ever growing government debt.

They are keeping prices up with ZIRP and QE to protect the financial system that holds all that debt (the other side of the credit to which you refer).  Creating more inflation, which they tell us is their goal, is NOT going to help mom and pop...nor is ZIRP.  In fact, it is PREVENTING the economy from healing.

...and yet, we can't fire them.

Wed, 03/19/2014 - 20:33 | 4570142 LetThemEatRand
LetThemEatRand's picture

"...and yet, we can't fire them."

Spot on.  Thus the two Team system.  The Fed chair (and more importantly the Fed itself) survives all changes of administration so long as Red and Blue are the options.  

Wed, 03/19/2014 - 20:12 | 4570086 buzzsaw99
buzzsaw99's picture

superficial and largely irrelevant analysis

earnings are a vapor. financials earnings in particular are totally bogus for the past two years. broad market earnings per share, which has been reported here extensively, are only propped up by debt fueled buybacks. with fed gub deficits now at $500B instead of $1.5B there is no way earnings can grow except by accounting shenanigans. margin is still on the precipice, it wasn't favorable earnings that caused the price per share higher, it was that, it was the fed along.

Wed, 03/19/2014 - 20:12 | 4570097 ebworthen
ebworthen's picture

Oh good Lord, just heard on PBS NewsHour reporting the First Wookie - with her Mom and Daughters in tow - are off on a jaunt to China to see the sights and discuss "education".

Wonder how many tax dollars this latest trip will cost?

Wed, 03/19/2014 - 20:27 | 4570128 One eyed man
One eyed man's picture

Better there than here.

The three rules of travelling in China:

1. Don't drink the water.

2. Don't eat the food.

3. Don't breathe the air.

I hope they enjoy the trip. They should really consider flying there via Malaysia Air. Much better than AF1.

Wed, 03/19/2014 - 21:25 | 4570366 LetThemEatRand
LetThemEatRand's picture

Pilots like her.  She can fix the hyperdrive if needed.

Wed, 03/19/2014 - 20:17 | 4570106 One eyed man
One eyed man's picture

"Analyst" estimates of non-GAAP "earnings" = highly refined BS.

Wed, 03/19/2014 - 20:19 | 4570123 Fred Hayek
Fred Hayek's picture

The article ignores the influence of the merde dollar on the profits of U.S. companies. As the crapola federal reserve note declines in value against even other crap currencies, profits from abroad become magically bigger when reported in dollars by your typical multinational corporation.

Anyway, back in mid December, David Stockman noted that the Russell 2000 index of small and medium capitalization companies was (at that time)trading at a ratio of 82 to 1 compared to the previous quarter's earnings. 82:1!!!!

No bubble here. No sirree. You suckers better jump in now or you'll miss this train going even higher. Yes sirree.

Wed, 03/19/2014 - 20:25 | 4570146 DirkDiggler11
DirkDiggler11's picture

So he thinks exuberance is once again returning to the markets?

Where the fudge has this cat been over the past three years ? This market is a Fed underwritten Ponzi scheme. Without the Fed we would be at Dow 100 right now.

Then again, without the Fed we would have never gotten into this fucking mess to begin with. Criminal ass bunch of sons a bitches.

Wed, 03/19/2014 - 21:22 | 4570300 Cacete de Ouro
Cacete de Ouro's picture

I have always had a problem with P/Es or Multiples or whatever you want to call them. While rudimentary, and serving as handy 'back of the scribble pad' ready reckoner, it is complete BS that a whole investment industry relies on them. It's a f@ckin' simple ratio for Chris' sake, as 10 years olds would learn in school.

The flaw is in the flexibility of both numbers. If the numerator is not playing ball, then the denominator can be rigged with ease. Just adjust the fu€kin spreadsheet. If the numerator is going crazy in either direction then the denominator can be kicked around until it is willing to say anything that helps the case of the sell side analyst.

Furthermore, the denominator can be zoomed forward in time or held to ransom as in, "you say you are worth 0.15 per share in 2016 or I'll break your fu{kin face, get it?" Like Frank Rizzo, "you buy this fuckin car or I break your fuckin face".. Then they start comparing P/Es across a sector or between sectors or over a whole market. This is just shamonic like some vodoo tribe might do for want of a better analogy. There is zero scientific basis to any of this.

Them there are legions of idiot sell side analysts who live and breath this rubbish and have been known to get very excited in bear markets where they think their P/Es are signalling that this stock is such a bargain down here. I heard this crap from analysts once too many times.

Multiple expansion is another BS phenomenon. I'd rather hear Bella Knox talk about multiple expansion than some Ivy League little jerk; you get the picture..

Wed, 03/19/2014 - 21:38 | 4570424 NOZZLE
NOZZLE's picture

I see nothing wrong with a mexican taco stand selling at 56 P/E or $598.  Its got a market cap of $18B and CAT has a market cap of $60B, maks perfect sense.

Thu, 03/20/2014 - 09:09 | 4571843 curbyourrisk
curbyourrisk's picture

When it comes to trading (pretty much the only game in town these days - it is simple)

The price of stocks, like anything, are based on one function and ONE function alone.  Supply and demand for such stock.  If there are more buyers than sellers, the stock is going higher - REGARDLESS OF THE NEWS OR UNDERLYING FUNDAMENTALS.  IT is a game, if you are on the right side of the game more often than not..  you will win.

When it comes to "investing" - does anyone still do that?  Fundamental and trends are what matters.  Price is only relevant to entry and exit zones.

 

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