Is This Market Overvalued? Not Yet

Joe Weisenthal notes David Rosenberg’s comments that the market is overvalued. I’m sorry, but I just don’t see how you can argue against this market on a valuation basis. Could there be a double-dip? Sure, that’s a risk and I can’t say how large, but the idea that the market is not only high, but dangerously high, makes no sense to me.

Rosenberg writes:

While we will not belabour the point, when all the write-downs are included, the trailing P/E on “reported” earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble.

Yes, but that’s extremely depressed trailing earnings. When the economy tanks like that, these metrics lose some of their usefulness. Also, when the market initially spikes, it’s common for the P/E Ratio to rise since stocks are going up while earnings are still going down.

Rosenberg notes this criticism and compares today’s valuations to previous depressed earnings environments. Still, outside the great depression, the historic comparisons aren’t in the ballpark. Once we get Q4 2008 off our backs, then things will start to look like normal and we can again use traditional metrics.

Another fact that the valuation argument must address is the low interest rates. As interest rates go down, valuations tend to rise in order to be competitive, so I would expect higher multiples.

Rosenberg rightly notes that relying on future earnings is tricky since these are rarely correct. That’s true, but this is a crucial point and it goes back to my disagreements with Nassim Taleb. The forecasts and models don’t need to be perfect. They simply need to be reasonable.

In making a valuation judgment we need to make reasonable assumptions. For example, I recently said that corporate profits are likely to grow faster than the economy for the next few quarters (say three year).

Here’s a look at corporate profits’ shares of the GDP.

As you can see, it looks to be below trend. Note that I’m not predicting exactly where it will go, but based on past information I’m making an assumption that profits will take up a larger share of the economy in the near future. As a result, I think the Street estimates of $90ish earnings for the S&P 500 in 2011 are reasonable, which makes the market well priced, if not a little on the cheap side.

Comments

[User 344476:]

I guess I'm wondering how we're going to make the $90ish level? I'm not saying we can't, but I'm wondering how? I think operating earnings (not real earnings) hit $91+ in 2007, just as the credit bubble burst. Obviously, they were a result of that bubble. Where would they have been without the bubble?

So, what will bring (the overstated) operating earnings to that $90ish level this time?

Oct 09 11:46 AM

[CautiousInv...:]

More Rosenberg. From today's missive:

ONE OVERVALUED MARKET

There has been plenty of debate over whether equities are overvalued or not, and certainly we would assume that many investors know where we stand on the topic. Let’s look at the facts now that the September data are in.

On an operating (“scrubbed”) basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x. Historically, when the economy is taking the turn away from contraction towards expansion, which indeed was the case in Q3, the trailing P/E multiple is 15x or half what it is today (and that 15x is also calculated off depressed earnings level of prior recessions – we have more on the historical comparisons below). While we will not belabour the point, when all the write-downs are included, the trailing P/E on “reported” earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble.

It is interesting to hear market bulls talk about how distorted it is to be using trailing multiples that include ‘recession earnings’ (even though using ‘forward’ earnings means relying on consensus forecasts on the future and these are rarely, if ever, correct). It is also interesting that the last time the multiple was this high was back in March 2002, again after a huge countertrend rally that deployed ‘recession earnings’ from the 2001 downturn. If memory serves us correctly, this was right around the time that the bear market rally started to roll over and in fact, six months later, the S&P 500 was hitting new lows and 34% lower than it was when the multiple had expanded to … today’s level!

Oct 09 03:11 PM

[Dave Wrixon:]

No, once the market value of the dollar hits fair value the markets will seem cheap. Of course they will be almost worthless in 2008 Dollars!

Oct 09 04:56 PM

[Swashbuckler:]

"As interest rates go down, valuations tend to rise in order to be competitive, so I would expect higher multiples." True, multiples on earnings today are higher in part because of low interest rates. But rates now have nowhere else to go but up. And the fed will be forced to raise them. And every rate tick upwards will stab the market. Nothing wrong with being long here, but you better have tight stops and be ready to bail.

Oct 09 09:57 PM

[conceptwizard:]

So far this year, nearly all of the earnings improvements have been achieved through major cost-cutting efforts. Overall selling and administrative costs among S.& P. 500 companies fell 5.7 percent in the second quarter versus the period a year earlier, according to a recent report by David J. Kostin, the chief United States equity strategist at Goldman Sachs.

This represents far more drastic cuts than were undertaken in the recessions of 1991 and 2001. Still, “you can only cut so much,” said Howard Silverblatt, senior index analyst at S& P. “At some point, you need to start seeing the business actually grow. You need to see increased sales” — sometimes called “top line” growth. That’s why Mr. Silverblatt says that revenue — not earnings — “will be the most important number for investors to watch.” The revenue declines are even more staggering on a dollar basis. From June 2008 to June 2009, revenue of the 500 companies tumbled by a total of $1.15 trillion. “That’s more than the entire fiscal stimulus,” Mr. Silverblatt said.

Sure, take ride on the never land equity train.

Oct 09 11:47 PM

[Kimball Corson:]

I think CautiousInvestor has it absolutely right here. In the free money environment we have been in where now the Fed is talking about whether to begin tightening monetary policy during what I contend is an L shaped non-recovery, it is very hard to believe this market has more top on it. Indeed, it doesn't even seem able to have its DOW break 10,000, which is a line in the credibility sand.

Oct 10 04:39 AM

[Tony Daltorio:]

The US stock market is back in bubble-valuation territory again, thanks to the Fed's free money (for Wall Street only) policy.

For the deflationists who can't seem to find inflation, just look to the US stock and Treasury markets - it's called asset inflation and is the most dangerous type of inflation because it causes massive bubbles which then burst and we all know what happens then.

Oct 10 10:48 AM

[Albertarocks:]

>Yes, but that’s extremely depressed trailing earnings. <

True enough. But read that multiple again. It's 140, not 40. If the multiple was only 40 instead of 140... it would still be historically overvalued.

Oct 10 11:36 AM

[ryanclarke:]

In order to justify these stock valuations the dollar must be devalued as well as the "true" corporate debt ... valued in terms of these dollars ... and both the debt and the currency must slowly continue to deflate for many years to come ... but my hunch is based on the news and internet gossip ... that foreign central banks worldwide have had enough of the U.S. Fed's mortgage refi game ... which is Summer's third stage to blast off for a new "bubble recovery" in energy. The central bankers outside the U.S. don't want to play the game because the "let's depreciate everything except Wall Street's pocketbook" is now more damaging to their regimes ... relative not only in terms of the U.S. dollar ... but to the value of their currencies as well.

Oct 10 08:10 PM

[enigmaman:]

I guess if you believe coming out of this recession our economy will look and behave much the same as it has in past recessions, going back to the 70s then maybe your right this market is undervalued and this time next year it will be just a faint memory like the others, but as is always the case we will only know who is right through hindsight, while I want to believe it just doesnt add up to be the same old same old

Oct 10 09:23 PM

[kotika98:]

Looking at that chart it seems that 9-10% is about fair, and we are at above 8%, so upside is not great here.

Oct 10 10:14 PM

[bricki:]

I don't believe trailing earnings that have massive write-offs due to one-off banking collapses embedded in them are worth squat in estimating P/E. 140 P/E isn't realistic.

Schiller's cyclic P/E numbers are a lot more useful. Schiller's numbers say that the market is now more or less fairly valued at a cyclically adjusted P/E of about 20 given that long term interest rates are currently low.

So long as interest rates remain low and corps can manage to increase profits through cost cutting and slow recovery going forward, stock prices can continue to increase.

Ultimately I'm with Swashbuckler - P/E multiples are likely to take a big hit once tightening commences. And that is inevitable. So make hay while the sun shines because when it starts raining it could rain for a while.

Oct 10 11:42 PM

[bbro:]

Finally somebody using the national income accounts.....S&P 500
is now 7.5% of GDP....historical median in a low inflation environment
(under 4% y-o-y) is 9.4%

Oct 11 04:49 AM

[nmelendez:]

What we need are salary increases. Increase everyone's salary by 20% and cut it out of the CEO's pay by taxing them. I like that idea! :)

Oct 11 10:22 AM