Wall Street's New Math

There is a new type of math circulating around Wall Street. It involves taking the current earnings of the S&P 500 and applying a single digit P/E ratio to it. The result is lower and lower price targets for the S&P 500. This is the polar opposite of the internet bubble where as stocks rose higher, price targets were raised.

The logic being used in this exercise is flawed. For instance, AIG (AIG) is scheduled to report a 60 billion dollar loss on Monday. The combined yearly profits of ExxonMobil (XOM) and Microsoft (MSFT) are 60 billion dollars. If you combine the three companies together they have no profits. Applying an 8 multiple to them yields a price of zero for the three companies. Are Microsoft and Exxon worth nothing because AIG reported a huge loss?

The same people that were saying stocks were cheap a year and a half ago because the forward P/E was cheap, are now saying the market is expensive at half the price. The only way to have a consistent benchmark is to normalize earnings. By applying a normalized profit margin, the market would have looked very expensive a year and a half ago and cheap today.

Why normalize profit margins? Profit margins are the most mean reverting series in capitalism. If there are high margins in a business more people are attracted to it and margins tend to decrease. If there are low margins people leave the business and margins tend to increase. Over the long term, profit margins of the S&P 500 have reverted to the mean. A year and a half ago profit margins were inflated by the expansion and use of leverage. Today, they are being depressed by the contraction and deleveraging.

A year ago everyone was looking at operating earnings, while now people want to look at GAAP earnings including writedowns. The problem is that one can always find a benchmark that will agree with their gut. Most who have invested long enough will realize that their gut is usually wrong.

On Friday, super bear Robert Prechter of Elliot Wave theory was on CNBC saying that he believed we were in the fifth and final wave down of this market decline. While I know nothing about Elliot Wave theory, I agree with him that this is the final wave down but for a different reason.

People are finally accepting that there is not an easy fix for this crisis. For the past year their were cries about "doing something". As if the government had a magic wand that could fix problems in one day that have been building up for decades. Hard decsions are finally being made. GE (GE) and JPMorgan (JPM) finally cut their dividend and Citigroup (C) is reducing debt by converting preferred shares into common equity. While the bear market likely has more damage to do, I believe we are getting late in the game.

To all those who insist on a single digit P/E ratio, there are literally hundreds of stocks that meet that criteria, including high quality companies. However, I doubt those people really want to buy stocks at single digit P/E ratios. They are just looking for an excuse to follow their trusty gut.

Comments

[zermux:]

Prechter did not say it was the final wave down. He was pretty specific in that he thought this bear market was likely to last for a few more years. His call to close out his futures short call, initiated in July 2007, was due to the fact that 800 points is a nice profit and we could be heading for some volatility. Additionally, for those of us who are a bit closer to what is going on, he is starting to fear about the stability of the financial system and its good to get the money from your counterparty whilst they are still solvent.

For those people who, unlike you, understand elliot wave theory: We are in wave 5 (down) of wave 1 (down) of wave c (down). After we hit the next bottom - maybe around 6400 on the dow - we should have a nice bounce, in wave 2 (up) of wave c (down). After that we hit a mega wave 3 (down) of wave C - this will be really nasty.

>>"On Friday, super bear Robert Prechter of Elliot Wave theory was on CNBC saying that he believed we were in the fifth and final wave down of this market decline. While I know nothing about Elliot Wave theory, I agree with him that this is the final wave down but for a different reason."

Mar 01 10:40 PM

[Moon Kil Woong:]

I agree with the author that market cap valuations based on PE ratios are about the silliest ways of evaluating the market you can get. Actually, I think you should look at the broad market for systemic risk. Like what is the cumulative debt/equity ratio. Even then, when an exchange switches one industry to another it will change this figure. Does that really change the entire market?

Under their system, the market is better if they just drop Citibank. But in reality, will that make the market more whole? I wonder what or why exactly they are trying to derive out of this magic figure anyway. What are they trying to imply about the market or even the Index they apply this too?

Mar 01 11:03 PM

[Steven Hansen:]

the market does not like uncertainty. i know of no index which we can mathematically calculate uncertainty - so this is not a math problem.

in uncertain situations where the net 'gut' feeling is negative - the market will go south.

Mar 02 03:52 AM

[CautiousInv...:]

I think Schiller's application of P/E ratios makes the most sense as he uses average earnings over the past ten years.

P/E ratios are just another tool in the kit a and do tend to be mean reverting.

The problem with them is that the P/E multiplier or ratio is highly sensitive to inflation, interest rates and expectations.

Mar 02 05:53 AM

[henarl:]

If you're going to play the entire market then use inverse ETFs. Better yet, researching individual companies should uncover a few underpriced stocks. Best of all, play the volatility of this market by short term trading and options.

Mar 02 11:51 AM

[carey_jim:]

The problem with using abstract, simplified business models (and their algebraic formulas) to make financial predictions is that factors that are left out of the abstract model can, suddenly and unexpectedly, become become predominant.

If there is a war or political revolution, for example, then the models are much less useful as panic and wartime conditions set in.

For example, even if it was true (and in my opinion it isn't) that World War II 'got America out of the Great Depression' it isn't a helpful explanation anymore than it would be helpful to say that putting the unemployed in prison will solve the unemployment problem.

The Russian communists solved their unemployment problem that way because their abstract labor model assumed that unemployment was impossible under communism because the communist government made jobs available for everyone. If anyone refused to work they were, by definition, shirkers and therefore criminals.

The P/E ratio of Exxon would become irrelevant (no matter how you measure it) to the future price of Exxon stock if, for example, a scientist announced that he had found a simple, inexpensive way to produce power from nuclear fission.

If that same scientist had a company with a stock that had a negative P/E ratio for ten years before the discovery, that mathematical fact would become irrelevant to the value of its new P/E ratio.

Mar 02 11:59 AM

[Patrick Garot:]

"Most who have invested long enough will realize that their gut is usually wrong."

I know the above is just an aside in a well-written article, but I'd like to offer a counterperspective. Your gut just needs to be supported by fundamental analysis, a back-to-the-basics approach.

I rarely have found my gut wrong. I think a lot of us go wrong when we lose discipline and follow (not our gut but) our head, which gets caught spinning around trend, momentum, other's counsel, etc. Particularly pernicious is our head's being informed by greed, as in watching a stock that has gone up 300%, and you can't believe you missed those "easy profits", so you finally board the train.

Other than that, thanks for the article.

Mar 02 12:25 PM

[Fred Voetsch:]

" year ago everyone was looking at operating earnings, while now people want to look at GAAP earnings including writedowns."

"as reported" earnings are what has been used throughout history going back to the beginnings of stock market history.

You can compare apples with oranges if you wish and keep buying into this market but fooling oneself seems like a poor idea to me.

In fact, as you will see if you look at S&P's earnings reports - www2.standardandpoors.... - you will notice that "as reported" and "operating" earnings are diverging so that NOW there is more reason for polyana's to use operating earnings rather than "as reported".

See papers.ssrn.com/sol3/p... for a quick summary on this.

Mar 02 01:55 PM

[know nothing:]

wow

Mar 02 08:45 PM