Recipe for an Expensive Market

by: Barry Ritholtz

My nomination for the greatest story never told is this under-reported tidbit, via AP:

For America's top 500 companies, the absence of extraordinary earnings news this past week pretty much guarantees 18 consecutive quarters of double-digit profit are over.

Wall Street analysts say fourth-quarter results are running just about on par with historical averages. As of Jan. 31, with 57 percent of S&P components reporting, companies have posted profit growth that has averaged 8.1 percent, the rating agency said.

But measure the latest results against the third-quarter's 23 percent performance and the fourth quarter pales in comparison.

Earnings have been on an astonishing tear. For the past 18 quarters, markets have seen a spike in reported corporate profitability. We attribute this run up to several factors:

  • Materials and Energy profits due to underlying commodities price gains;
  • Banking sector profitability courtesy of ultra low rates;
  • Financial sector gains via huge liquidity leading to IPOs, M&A, takeouts;
  • An Unprecedented Mass of Buybacks;
  • There can be no doubt that corporate balance sheets are better than they have been in decades. Earnings quality is also notably improved.

    But do not confuse financial engineering with cheap stock prices. Like so much else we see lately, valuation is also a bifurcated affair, with the cheapest large stocks making the rest of the S&P500 appear less pricey than it really is.

    Blame it on Market Cap.

    This is in some ways somewhat parallel to what happened during the run up in 1999 and 2000. A small handful of megacap stocks drove the indices higher, while much of the rest of the market under-performed. If fund managers didn't own the nineties equivalent of the nifty fifty, they didn't keep up with their benchmarks.

    Today, instead of megacaps driving price, they are driving valuations. Those are the findings of Dresdner Kleinwort Group:

    Recent research by Dresdner found that only six very big companies make up the top decile, or 10th, of the market value of the Morgan Stanley Capital International Europe Index. What's more, the six -- Royal Dutch Shell Plc (NYSE:RDS.A), HSBC Holdings Plc (NYSE:HSBC), BP Plc (NYSE:BP), Roche Holding AG (OTCQX:RHHBY), Total SA (NYSE:TOT), and GlaxoSmithKline Plc (NYSE:GSK) - have an average weight-adjusted P/E ratio of 11.2. The top 30 percent of the European stock market's value consists of 26 stocks with an average weighted P/E ratio of 11.9, according to Dresdner.

    Now for the kicker. The bottom 10 percent - which contains 293 stocks - is trading at 16 times projected earnings...

    Ditto the U.S., where just four companies - Exxon Mobil Corp. (NYSE:XOM), General Electric Co. (NYSE:GE), Microsoft Corp. (NASDAQ:MSFT), and Citigroup Inc. (NYSE:C) - make up the top decile of the Standard & Poor's 500 Index. And a mere 19 companies with an average P/E of 14 comprise the top 30 percent of the market's value. By contrast, the bottom 10 percent consists of 206 companies with an average P/E of 16.2, according to Dresdner.

    If we combine these two issues - earnings decelerating below double digit gains, and valuations appearing reasonable only due to a skewing effect of 4 major stocks - you have a recipe for an expensive, not a cheap market.


    S&P's Corporate Growth Streak Snapped
    Big U.S. Companies Not Seen Continuing Double-Digit Growth Pattern
    Joe Bel Bruno
    AP Business, Friday February 2, 4:49 pm ET

    Stocks Look Cheap? Not Without the Big Guys
    Michael R. Sesit
    Bloomberg, Feb. 6 2007