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.

Yesterday we looked at what happens when the S&P 500 is this far above its long term moving average. If you haven’t yet read that, click on the previous link and read it first because then what follows will make much more sense.

As you’d expect, when the stock market is stretched 20% or more above its 200 day moving average, it has a hard time continuing such a heady move. Instead, we find that the market pauses or retreats in the short term (1 to 3 months). But as Barry pointed out in the comments, there is a difference to how the market behaves in a bear market rally and a real secular bull market. With that in mind let’s analyze the data further.

If you looked at the historical data table that I showed outlining the previous extremes you probably noticed that 4 out of the 13 instances occur very close together in late 1982 and early 1983. This was, of course, the launch pad of the super bull market. The S&P 500 closed at 102.84 on August 10th 1982 and never looked back.

So naturally, there is a cluster of data points (chart below) as the market went on a rampage. This also explains why the 6 month period returns are so inordinately high:

That’s a lot of red marks! Between January 1st, 1980 and June 30th, 1983 there were 28 days when the S&P 500 was above its 200 day moving average by at least 19.5%.

If you look at the chart carefully, you’ll notice something remarkable. Even in such a super-strong bull market, this simple indicator is still able to identify short term tops in the market. But in the intermediate term, the market simply ignored any and all overbought signals. And eventually, by May 1983, they were’nt even able to mark a teeny bit of a correction. After all, in a strong bull market, ‘overbought’ is meaningless.

The question then is, are we about to see something similar? That is, do bull market rules apply? will this most recent extreme be simply the first of many? will the stock market simply ignore each and every one as it goes on yet another rampage the way it did in 1982?

No one knows of course. But personally, I think such a scenario to be highly improbable. It just wouldn’t make sense to expect a repeat of the 1982 experience. For one, we do not have the volume to fuel such a move. Second, and most importantly, we do not have the valuation.

I know, I know, fundamental analysis is for chumps. But I’m not talking about trying to game next quarters earnings estimate. I’m referring to the aggregate valuation of the market. Something for which we have much evidence to indicate excellent predictive value in the long term. For details, I refer you to Shiller’s excellent book: “Irrational Exuberance“.

Let’s pretend to ignore that the market has never rallied 60% in 6 months before. Let’s also ignore that never before has it performed even remotely close to that when the unemployment rate was this high. And ignore that corporate insiders are selling like lemmings. That sentiment is way too optimistic. That 95% of issues closed above their 200 day moving average (and 93% above their 50 day moving average). Even if we brush all of that and more under the rug, we can’t ignore how expensive the market is here:

• the trailing P/E (for operating earnings) is 26
• at the onset of the bear market in October 2007, it was 19
• the trailing Price Earnings ratio is 184 (reported earnings)
• on October 2007 it was merely 23 (in October 1987 it was just 20)
• the price to dividend ratio (click for chart) is at 53
• on October 2007 it was 55 and way back at the start of the super bull (1982) it was 16
• based on one year forward (operating) earnings the P/E ratio is 16 - highest in 5 years
• on October 2007 the forward est P/E was 14 (same as on Oct 1987)
• Price to Book ratio is 2.3 - August 1982 it was below 1 (discount to book)
• based on recent Tobin’s Q analysis, the market is 40% overvalued

While the market is a forward discounting mechanism, there is a limit to how much and how far ahead it can do so. Arguably, at these prices, the stock market is discounting the next 3 years operating earnings (2012). Historically, the market faces strong headwinds when P/E reaches 25. The average 1 year return at that valuation (or higher) is -0.3%. (All valuation data sourced from David Rosenberg’s invaluable research at Gluskin Sheff).

All of the above leads me to conclude that the most apt script is the one we’ve seen before many times in the aftermath of secular bear markets. While the performance of the stock market since March has been more than impressive, the stage is not otherwise set for the launch of a secular bull market.

Here’s the thing. Earnings have collapsed. Utterly and completely. Like a house of cards. Like never before.

And because equity prices only fell by ~50%, that means the price earnings ratio skyrocketed to the stratosphere and beyond. Just look at the chart of the S&P 500 index’s P/E ratio - it looks like it just fell through a wormhole:

Source: Chart of the Day

Honestly, my initial reaction was to ignore this latest chart. First, because we already went over this months ago when the P/E ratio was 122: How The Price Earnings Ratio Can Fool You. But also because this whole issue is truly meaningless.

But then I realized that this chart is making the rounds on the internet at a torrid pace. It is being forwarded and many other bloggers are featuring it with a bearish slant. So while it really is a distraction, perhaps there’s something of value here. Not the data set graphed but rather the reaction of people and their fixation on this useless little statistic.

If anything, the morbid fascination with the gloomy and shocking picture the above chart depicts tells us about the public mood out there. And from a contrarian point of view, this is the sort of ‘worry’ that bull markets proverbially like to climb.

Last Friday we looked at the unprecedented earnings collapse that has fueled this bear market. The chart below is the flip side, showing the impact on the S&P 500’s valuation through the Price/Earnings ratio:

Source: Chart of the Day

While the P/E ratio is a familiar rule of thumb that helps us to calculate the relative value of the stock market, like any metric it has a handicap. Looking at the chart, it is clear what that is for the PE ratio. Just imagine how ridiculously meaningless the ratio would be if we actually see negative earnings as many are predicting we will, for the first time ever!

But there’s no reason to panic, running out into the street screaming at the top of your lungs. The fact that the S&P 500’s price earnings ratio is 122.45 right now, once again proves that the price dividend ratio is a superior measure to price earnings. Dividends are a much better way of measuring value because unlike earnings, they are not prone to creative accounting and are considered sacrosanct.

While the P/E ratio is finding irrelevance in the stratosphere, the price dividend ratio is 38.6 - click previous link to see a historical chart of the price dividend ratio. And click this following link to see a chart of the price earnings ratio before the silliness began.

As S&P 500 earnings have collapsed from $62.28 - a year ago - to the present’s miserly $7.21, dividends have been much more robust. Dividends were $28.93 in May 2008 and currently they are $22.87 - a fall of just 21%. The Dow Jones Industrial dividend has fallen even less, 3.6%.

In the end, this is why we use many different methods to measure and analyse the market. Sooner or later, any one of them will go bonkers and provide useless output. At that point, it is important to realize that and not follow it over the ledge like lemmings.

With earnings season once again around the corner, this perspective on the market has extra relevance:

Source: Decision Point

Once in a blue moon, the market trades at prices which take it to a “value based buying opportunity”. But notice that looking back, it hasn’t for a long time. According to this chart, if we do revisit that scenario again, we would be at levels last seen in 1996 (S&P 500 ~650).

Which reminds me of this other chart, showing just how low a serious bear market can take prices.

I highly recommend Decision Point, the source of the chart above. Thanks to Dr. Brett, you can have free access to their great site until October 26th, 2008. Just login as a regular member would using User ID: magic55 and Password: moments.