Trader’s Narrative

Guest post by Wayne Whaley, CTA

Valuation is a funny bird because we are forced to use trailing information to attempt to estimate whether the market is fairly priced relative to future information (earnings) and there is substantial guesswork involved.

This allows analysts a great deal of flexibility to mode the statistics to serve one’s agenda. I read an article published on Oct 23rd in a prominent online finance page that stated that the bulls should be disturbed to buy the stock market at 136 times earnings. That article prompted me do the following mental gymnastics.

What we do know for a fact:

So using the trailing 12 months earnings of $7.51 for the four quarters that we have full earnings for and the S&P 500 value as I type of 1050.0, we have a market trading at a P/E of (1050.0 divided by 7.51) 139.8 times earnings.

If I read their website correctly, Standard and Poor’s estimates that with 37% of companies 09 third quarter earnings in, that the 3rd quarter estimate is $13.14. This would take the trailing 12 month earnings to $10.92 at the end of the third quarter and put the current P/E at 1050/10.92 = 96.1 times trailing earnings.

But the big change comes at the end of the year. We will drop the -$23.25 during the height of banking crisis and add some number likely to come in between 10 and 15. To avoid picking numbers to serve our purpose, let’s be conservative and assume $10 a share for the fourth quarter. This would take earnings for 2009 to (7.52+13.51+13.14+10) = $44.17. With the S&P 500 at 1050, that would give us a conservative estimate of P/E for 2009 of 1050/44.17 = 23.77, a tad bit below the current +100.

A P/E of 23.77 is above the historic norm of 19, but inverts to an earnings yield equivalent of 4.2% which is equivalent to the current return of the 30 year bond and higher than any other return on the shorter end of the yield curve.

This is justified by a more detailed look at earnings vs. interest rates. I use an average interest rate (AIR) which is the average of the 3 Month T-bill, 5 Year T-Note and 30 Year T-Bond. Since 1970, whenever the AIR is below 5.0, the average P/E has been 29.

So without a great deal of imagination, one can put together a strong case for stocks being at least fairly valued at 1050. If you were brave enough, you could argue that stocks are even cheap when compared to returns on alternative investments. Of course, you can argue that the market is selling at 140 times earnings as well.

Personally, for the reasons above, my suggestion is to not rely to much on valuation as a timing tool and focus more on what the tape is telling you.

Guest Post by Vadim Pokhlebkin

It’s corporate earnings season again, and everywhere you turn, analysts talk about the influence of earnings on the broad stock market:

• US Stocks Surge On Data, 3Q Earnings From JPMorgan, Intel (Wall Street Journal)
• Stocks Open Down on J&J Earnings (Washington Post)
• European Stocks Surge; US Earnings Lift Mood (Wall Street Journal)

With so much emphasis on earnings, this may come as a shock: The idea of earnings driving the broad stock market is a myth.

When making a statement like that, you’d better have proof. Robert Prechter, EWI’s founder and CEO, presented some of it in his 1999 Wave Principle of Human Social Behavior:

Are stocks driven by corporate earnings? In June 1991, The Wall Street Journal reported on a study by Goldman Sachs’s Barrie Wigmore, who found that “only 35% of stock price growth [in the 1980s] can be attributed to earnings and interest rates.” Wigmore concludes that all the rest is due simply to changing social attitudes toward holding stocks. Says the Journal, “[This] may have just blown a hole through this most cherished of Wall Street convictions.”

What about simply the trend of earnings vs. the stock market? Well, since 1932, corporate profits have been down in 19 years. The Dow rose in 14 of those years. In 1973-74, the Dow fell 46% while earnings rose 47%. 12-month earnings peaked at the bear market low. Earnings do not drive stocks.

And in 2004, EWI’s monthly Elliott Wave Financial Forecast added this chart and comment:

Earnings don’t drive stock prices. We’ve said it a thousand times and showed the history that proves the point time and again. But that’s not to say earnings don’t matter. When earnings give investors a rising sense of confidence, they can be a powerful backdrop for a downturn in stock prices. This was certainly true in 2000, as the chart shows. Peak earnings coincided with the stock market’s all-time high and stayed strong right through the third quarter before finally succumbing to the bear market in stock prices. Investors who bought stocks based on strong earnings (and the trend of higher earnings) got killed.

So if earnings don’t drive the stock market’s broad trend, what does? The Elliott Wave Principle says that what shapes stock market trends is how investors collectively feel about the future. Investors’ mood — or social mood — changes before “the fundamentals” reflect that change, which is why trying to predict the markets by following the earnings reports and other “fundamentals” will often leave you puzzled. The chart above makes that clear.

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Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

A reader, Wayne Whaley, who is also a veteran trader and registered CTA sends in this concise report on the earnings season:

“About 1/2 of second quarter earnings are in and we have a pretty good estimate now of what final earnings should look like at the end of the quarter.

With interest rates at current levels, you can make a mathematical case for P/Es in the 25-30 range

Observations:

Including the 2009 Second Quarter Estimate of 7.27, and using 979.26 as current S&P price

1) The P/E using last 4 quarters for E is 771.07
2) The P/E using last 8 quarters annualized for E is 37.21
3) The P/E using Standard & Poors estimate for 2009 earnings as E is 32.67
4) The P/E using Standard & Poors estimate for 2010 earnings for E is 26.28
5) Earnings for the third quarter need to come in around $8.50 to avoid a negative trailing one year earnings, which from the information I have would be a first (at least in the last century).

At best, you could argue that stocks are fairly valued even using estimates for 2010 earnings. Valuation techniques are interesting to calculate and make for interesting conversation but can be misleading for market timing purposes as the market can be over (1995-2000) or underpriced (1950’s) for years, especially when earnings and money supply are moving targets.”

The chart below provides perspective on the earnings collapse by focusing on 12-month, as reported S&P 500 earnings. This quarters earnings are expected to have fallen over 98% since topping in the third quarter of 2007. That makes this, by far, the worst decline on record all the way back to 1936 - the earliest we have data. In fact, real earnings have dropped so far that in the coming quarter will see the first 12-month period where the S&P 500 earnings are actually negative!

Source: Chart of the Day

While this is certainly makes for a great story that we can tell and retell to the grandkids (boring them to tears), it doesn’t really mean much. We are at an extraordinary moment in economic history. One where we are clinging to the ledge by our fingernails and peering down at the precipice below. In such unorthodox times, orthodox measures such as the price earnings ratio can fool, rather than inform you.

First the bad news: earnings are horrible. Downright depressing actually. As the chart below illustrates, we’ve seen nothing short of an utter collapse during the most recent bear market:

Clearly what we’re going through is not your average, plain-vanilla recession. That would be the blue dashed line above. Even the last recession which came about as a result of the popping of a massive speculative bubble in technology shares and topped off by the economic body-blow from the September 11th attacks pale in comparison. What we’re seeing is the single most severe drop-off in earnings on the record.

Now for the good news. It may not matter at all - that is, when it comes to the stock market. Of course, to the economy, the employees and companies involved there is a significant consequence and I don’t mean to trivialize it. But the stock market is not the economy. For an example of what I mean, consider the company that started the most recent earnings season.

Alcoa (AA) released their earnings report after market close on Tuesday. They reported a loss of about half a billion for the first quarter. As you might expect, at first its stock price fell in after-hours trading but it closed higher the next day (Wednesday shown by green arrow) and today it gapped up and closed almost 10% higher:

Is this normal? Yes, of course. In contrast to what you may have heard, stock prices are not driven by earnings. This is one of the key characteristics of the stock market that throws a lot of novices because it just doesn’t make sense. But it does, once you realize that prices are set by a number of factors and while earnings are certainly part of the recipe, they are not the dominant ingredient.

If you look at enough charts you’ll see stock prices that are falling for companies that are reporting increased earnings and also stock prices that rise with decreased earnings. The key isn’t earnings, which after all, can be heavily manipulated unlike dividends. But rather the meaning that investors attribute to them. In other words, the price-earnings ratio. And that, is all about “animal spirits” or sentiment.

Today, most financial companies are an endangered species. But other brokers and investment banks may be struggling and getting government bailout money to spend on bonuses, Interactive Brokers (IBKR) goes from strength to strength.

They recently reported earnings for 2008 and for the first time they broke the billion dollar mark for income (before taxes and minority interests). When you consider this was done on revenues of only $1.85 billion, you get an idea of how tight a ship they run.

I’ve mentioned before that they are one of my favorite brokers and arguably the best broker out there for the non-proprietary trader. As a customer, it’s good to know that your broker is on solid financial footing - one less thing to worry about.

If you trade with them you soon get to love their SMART routing which gets you better prices at surprising frequency. Based on independent analysis by the Transaction Auditing Group, IB’s SMART routing beats the competition. You can get the full details here.

As well, they are continuing to roll out new products and expand their already impressive market reach:

• Korean Kospi 200 Futures and Index Options (for US resident customers) soon
• National Stock Exchange of India (NSE) equity - initially to residents of India but eventually to others
• …to be then followed by NSE index futures trading
• addition of American Century no-load mutual funds

You could argue that IB is becoming a quasi-prime broker. They are a one stop shop for equities, derivatives (options, as well as futures) in more than a dozen international stock markets. And they have forex to boot. Add to that mutual funds marketplace they implemented in recent years and you’ve got a top-notch brokerage firm.

But that doesn’t mean they are the perfect fit for you. I think they are definitely worth a look if you are an active trader or have a large portfolio. But you should do your own due diligence to find a broker that you’re happy with.

Here’s a chart of Interactive Broker’s (IBKR) stock price since their IPO:

As you can see from the chart, fundamentals count… but not really