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Making
a Bullish Mountain Out of a Molehill |
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Back on February
25th, we took a long and scrutinizing look at the broad market's valuation
- current and projected. At the time, many of Q4-2009's earnings
were still being reported, and Standard & Poor's had yet to give us
a forecast for 2011's operating earnings.
A lot's happened
in the last month and a half. Not only do we now have operating earnings
outlooks for 2011, but we've also got updates for all of 2010's
numbers. Let's just say the 7.7% gain the market has given us since then
makes a little sense, but also leaves behind some big questions.
We'll get to
the updated earnings outlook below, but first, we want to mention
a blog entry from Tuesday.... "Employment
Reality, in Pictures". It's a perspective about jobs (and joblessness)
you're not getting anywhere else. Just be sure to factor in today's updated
claims numbers. It's well worth a look.
As
of our February
25th look (and as of February 25th prices), the S&P 500's
trailing twelve-month P/E was a moderate 19.47; the GAAP P/E ratio was
an equally moderate 21.45. For comparison, the long-term averages for those
numbers are 19.40 and 26.18, respectively. So, at those prices, stocks
appeared to be fairly valued.
 Now
fast forward to today. At today's price of 1186 for the S&P 500, the
trailing twelve-month operating P/E rolls in at a nice 18.56, and the GAAP
P/E is a palatable 20.01... both under the norms, and the result of a great
number of upside earnings surprises in the last two months.
What's wrong
with that? Nothing - it's good news. In fact, it fundamentally justifies
(sort of) the recent rally we've seen the market make, even if the
big move higher wasn't technically sound.
And what about
the updated earnings forecasts and valuations? That's where things get
really interesting, and not for the better .
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Projected
Earnings Growth |
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The reported
(GAAP) earnings-per-share estimates were indeed raised for the next two
years. On the nearby chart, you can easily compare the original outlooks
(red) with the new outlooks (blue). Just for some scope, the Q1-2011 GAAP
EPS estimate for the S&P 500 was raised from $17.25 to $18.26... a
5.8% increase. And, similar increases were applied to the next eight quarters
(the second of which we're already in).
 We
didn't have 2011 operating EPS estimates in our last look, but we did
have 2010's. Still, one would think that operating earnings outlooks would
have improved for 2010 to a degree reflective of the improved GAAP earnings
outlooks. But, they weren't - they were basically the same. That's not
even the odd part though.
GAAP earnings
are actually expected to sink in the latter part of 2012 (assuming the
outlooks have actually been updated), yet operating earnings are expected
to keep climbing until reaching $25.50 per share at the end of 2012.....a
48% increase from Q4-2009's results. With that kind of growth outlook,
it's no wonder stocks have been going hog-wild over the last month
and a half.
This,
however, is where we take (one) issue with the earnings outlook and the
way the market's been behaving since mid-February. The operating numbers
look fantastic - they just don't feel plausible.
We've never
minced our opinion that we're in a recovery mode, but a 48% increase
in operating earnings in two years' time? Even worse, reported/GAAP
('real') earnings are expected to fall throughout 2010, spike in early
2011, and then fade again. Like we mentioned in a prior newsletter, investors
will be a little tolerant of the GAAP/operating earnings disparity
for a while coming out of a recession, but that patience may wear thin
by 2011.... and that's assuming the market can actually achieve those
incredibly-lofty expectations.
The market's
already baked in those excessive earnings outlooks though... and then
some .
Take a look
at the nearby chart. You'll see the forward-looking GAAP P/E ratio for
the end of 2010 moved from 18.81 to 19.10 (+1.6%), thanks to a big buying
spree rooted in a not-so-big increase in estimated GAAP earnings.
For 2011 year-end, the GAAP P/E ratio has moved to from 15.96 to 16.43
(+2.9%) because of the rally.
 Yes,
they're small percentage increases, but they're not small when talking
about valuations.... especially when the earnings they're based
upon are questionable at best.
The bump in
the operating P/E ratios over the last two months has been even
more dramatic, in a worrisome way. Investors were previously content to
own stocks at prices based on ending 2010 with an operating P/E ratio of
14.15. Now - and even with the increased earnings estimates - investors
say they're satisfied to own stocks at prices based on ending 2010 with
an operating P/E of 17.25.... a whopping 21.9% increase in the market's
forward-looking operating P/E for the current year.
And that last
factoid
may be the best one to ask the rhetorical question of (and make a point
in the process).... what's happened in the last two months that justifiably
made stocks 21.9% more valuable then they were in mid-February?
One could argue
it
is indeed the improved earnings outlooks prompting the rally, but that
only explains about 6% of the 22% increase in the forecasted P/E ratio;
where'd the other 16% come from? One could also argue that less
risk now justifies higher valuations, but be realistic - is there really
any less risk now than there was in February?
One may even
argue that the projected P/E ratios for 2010 and 2011 are under long-term
norms... an argument that actually holds a little water. But, as we mentioned
back in February, P/E
ratios tend to sink - not rise - for a couple of years after a recession
before they hit a bottom. For this stage of the market cycle, rising P/E
ratios are actually moving in the wrong direction; the fact that the
outlooks may be out of reach is irrelevant. It's counter-intuitive,
but a reality nonetheless.
In simplest
terms, the improved earnings outlooks over the last six weeks were tepid
at best, and questionable at worst. Yet, the market interpreted
those new outlooks in the absolute best possible light anyway, and
then continued to take the euphoria a little too far.
Therein lies
the problem, and the reason we continue to look for at least a moderate
correction - this recent rally is tough to justify from a technical, and
now a fundamental, perspective. We still can't say when it'll happen
(or even if), but if we had to guess, we'd say the market's going
to do the same math we just did sooner than later. When it does, down we
go.
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Updated: 8:15 pm PDT (03:15 GMT), November 2, 2010
