Are Stocks Actually Cheap Now?

There seems to be universal agreement that stocks are cheap. But like many things on which there is universal agreement, that assertion may not be true. Hard to believe, given that every talking head on CNBC seems to include “cheap valuations” among the reasons for the recent bull market. Even President Obama recently made a case for the stock market based on low price to earnings ratios. But are stocks, in fact, cheap?

Part of the problem is that there are many different ways of evaluating earnings, and it’s often not clear which metric is being used when valuations are discussed. The two main distinctions are forward vs. historical and operating vs. reported. Many different labels are used for these categories; historical is often referred to as “trailing”, and operating earnings are often known as “core” earnings, and by other labels.

All investors really care about is forward earnings; what a company will earn in the future. But future earnings are often best judged by historical earnings, simply because past earnings are known, and future earnings are a guess; often, a very bad guess, as recent earnings estimates have shown. Even within historical earnings, there are different ways of analyzing the past.

Traditionally, the last 12 months of earnings have been the most common gauge of earnings. But when earnings have been trending sharply down, as is recently the case, stock market bulls prefer to use average earnings over the last 10 years, sometimes known as PE10. According to Robert Schiller, this ratio is traditionally around 16, and stocks are now trading at about 13 times the last 10 years earnings. (This ratio is sometimes also known as ‘averaged earnings.’) The problem with this metric is that the last 10 years may be very different from the next 10 years. For instance, earnings in the last 10 years were supercharged by the use of leverage; financial firms often borrowed 30, 40, or even 50 times the amount of their own equity to make investments. If, as appears to be the case, we are entering an era of lower leverage ratios, then earnings will be much lower.

Reported earnings are the numbers that companies officially, well, report, when they announce their earnings. Often they will also report “core” or “operating” earnings, which represents the results of the business without “one-time” events. These supposedly one time events are not included because they are considered to be aberrations which will not affect the results going forward. These events can be positive or negative, and might represent the write down of goodwill for an acquired business that is not performing well, or the sale of real estate for a company that is not in the business of selling real estate.

Lately, many businesses have taken huge write downs to reflect the falling value of assets like real estate or stock investments. In many cases the write downs do not reflect assets that have been sold, but the value is reduced on the company’s balance sheet. The problem with these “one-time” write offs is they often seem to occur much more than one time – sometimes on a regular basis. Like most accounting, there is a major element of discretion in what constitutes a one time event and what is part of ongoing business activity. When banks said they were profitable in January and February of this year, what they meant was that their core operating business was profitable, without considering write downs that might have to be taken at the end of the quarter.

Like many things in life, making sense of corporate earnings depends on whether you prefer to take an optimistic or pessimistic view of the world. Contrary to all the white noise on TV, using the most conservative metric, last 12 months reported earnings, stocks are very expensive. Based on the S&P closing price of about 815 on March 27, 2009, and the most recently reported earnings of about $16 per share for 2008, stocks are trading at a PE of over 50, as compared to a historical average of about 14. On the other hand, the most optimistic way of looking at earnings, at the moment, is to take S&P’s official earnings estimates of about $62 a share for 2009, and you get a forward PE of about 13.

So what is the “real” PE ratio? 13 or 50? You have to make that call, depending on the metric you choose. (Which, incidentally, will also change if you use another exchange, index, like DOW or NASDAQ, which cover different companies with a different set of earnings. And, of course, the ratios will completely change for companies outside the US, which can trade at markedly different PEs than US stocks. We should also note here that the ratios change every moment of every trading day. As stock prices rise, so do PE ratios, so Monday’s PE may be different than Tuesday's, given the extreme volatility we have suffered recently. Not only do the price levels change, but in a much more subtle way the entire historical data set is increased.)

Confused? Of course, for simplicity’s sake, this is a very crude handling of a very complex topic, with many nuances. Only a fool tries to predict the futures of markets, but I’ll be that fool for a moment and take my guess. After all, analysis involving PEs and other metrics have no value if they have no predictive power. The official estimates have earnings increasing 26% from 2008 to 2009. I don’t think that will happen. I think first quarter earnings will come in well below estimates, and the same will be true for all of 2009. If 2009 earnings are actually 45 on the S&P rather than 62, a forward PE of 12 would have the S&P at 540, down about one third from current levels.

Disclosure: Short various market indexes and individual stocks, long individual stocks.

Comments

[Dave Wrixon:]

Sanity returns to the discussion.

Mar 29 06:58 AM

[prudentinve...:]

Excellent analysis, thanks. Your statement "...... So what is the “real” PE ratio? 13 or 50? You have to make that call......". highlights what many people miss, that the "E" can be whatever you want, within a very wide range.

I've always had misgivings about "E", and prefer "D". Reported earnings can be manipulated, but dividends are real, and no one can creatively tell you that the dividend was $2/share, then only send you $1/share.

So, if you want to cut through the hype, just look at your own real earnings as a shareholder, which are the dividends. These continue to be cut by one company after another at an alarming rate, illustrating that stocks are now rather overvalued on a "forward P/D" basis.

Mar 29 08:13 AM

[mrbill:]

It's a traders market.

Mar 29 09:04 AM

[Rick Urban:]

This article is one man's opinion, the shortie opinion. When markets droped to it's 12 year lows, it was not based on P/E or any other matrix. It was based on panic selling. Markets are discounting mechanism, so looking forward after earnings start to improve (and they will), the stocks are cheap, very cheap right now. If you are an investor then couple of quartes of bad earnings means nothing. And by the way, traders don't look at the fundamentals. That's what the markets are right now, the trader's and speculator's markets. So you as a short, must convince yourself that stocks are very expensive right now.
That is a very reason that you will never make really money in the stock market as you can not see an opportunity when there is one.
Just go with CDs. They will give you guaranted 1.5%.

Mar 29 10:27 AM

[socrateazz:]

All evaluations are subjective What is important is how the traders views change. If they change favorably things will go up anyway. If they change negatively then stocks will go down. Underlying that is government policy. Providing liquidity will encourage companies and buyers of stocks On the negative side, The president thinks he can pull that wealth back out soon to cut the deficit! The question is? If I give You $30,000 and you buy a car with it, And I want the $30,000 dollars back next year, will you be in better shape financally next year as a result? Would you do it? That is like the folk who borrow from their paycheck to buy what they want today. Do they ever catch up? What does it cost them? Obama offers that as a way to save the economy. Will it work? What do you think?

Mar 29 12:15 PM

[Rcsam:]

That is probably the dumbest analysis I have ever heard. If earnings went negative, based on your analysis, the stock market would be worthless. You have to normalize earnings. Just as you cannot put a peak multiple on peak earnings, you cannot put an average multiple on trough earnings. The earnings of the S&P 500 normalized is about $70. That is a13% ROE. The ROE at the peak was 18% in 2006. Twelve times that is 840. Since earnings are almost meaningless in this free fall economy a better guage is the value of stocks relative to GNP. It is now 65% down from 120% in 2006 and above the depression level of 40% and 45% in 1974.


On Mar 29 06:58 AM Dave Wrixon wrote:

> Sanity returns to the discussion.

Mar 29 01:38 PM

[ksmithdc:]

Interesting read, thanks.

Mar 29 02:53 PM

[mgcolin:]

It will be clear that valuations are cheap when 2 things happen - Stock buybacks return and/or insider buying picks up. Executives making these decisions have the inside information on the economic fundamentals, and they are still scared to death as far as I can tell - except for Immelt who was buying GE at 40, 30, 8....so he obviously doesn't know what is going on with his company. When the guys at UTX, HP, INTC, start buying then we'll know the bottom is past.

Mar 29 04:56 PM

[Prudent Man...:]

The past decade is hardly a guide for a contracting world economy which probably will last for another decade. If the economy has contracted 40% it will have to grow 67 percent to get back to where it was before this recession . Pile upon consumer/taxpayers trillions of dollars in addition debt and if one sees strong economic growth in the future I would like to buy a pair of those rose colored glasses.

This is not a video game this is reality.

Mar 29 05:16 PM

[Fighting Yoda:]

PE10 is good does actually predict well, but does not standup logically – look forward. I think we have to look at the past for Es and PEs. E would keep falling for some time, likely no more than $50 this year, 45 or 55 next year. PE can go down to 7 in a bear market, 10 is good bear market average. PE 1974 – ‘84 – 9.5, low of 7.3 in’74, high of 12.4 in 1983.

So 10x$50 – would be S&P 500 at 500. We will get there, notwithstanding the euphoria and money printing.

Mar 29 05:46 PM

[Old Trader:]

An interesting piece which brings up some valid points, but I'm not certain that I agree with the author's premise that trailing PE (going back the last 12 months) is the most "conservative" measure. I prefer what is referred to as PE10 (averaging the last 10 years). This is a more "normalized" measure that gives a truer picture, imho. The author makes the point that the last decade may well be distorted because of leverage employed, but the amount of leverage grew over the period. It did NOT spring full-blown at the start of the decade, so while there might be some amount of skewing in the data for the previous decade, I feel it still gives a truer view of what the market (or any stock's) PE might be.

Bear market PEs can, and do drop to 10, or lower, due to a combination of falling earnings and collapsing PE multiples, so even using 13 as the current PE for the S&P, makes stocks "somewhat cheaper", rather than screaming deals.

A "conservative" point of view would be a PE of 10, imo...single digits MIGHT be a stretch, depending on how quickly and effectively all of the planned stimulus plans work.

Mar 29 10:03 PM

[John Groom:]

When, exactly, willl earnings "normalize" at 70? In this decade?


On Mar 29 01:38 PM Rcsam wrote:

> That is probably the dumbest analysis I have ever heard. If earnings
> went negative, based on your analysis, the stock market would be
> worthless. You have to normalize earnings. Just as you cannot put
> a peak multiple on peak earnings, you cannot put an average multiple
> on trough earnings. The earnings of the S&P 500 normalized is
> about $70. That is a13% ROE. The ROE at the peak was 18% in 2006.
> Twelve times that is 840. Since earnings are almost meaningless in
> this free fall economy a better guage is the value of stocks relative
> to GNP. It is now 65% down from 120% in 2006 and above the depression
> level of 40% and 45% in 1974.

Mar 31 01:40 PM