This Time It's Different

| About: SPDR S&P (SPY)

Summary

Forward P/E estimates have been justification for high stock market valuations for quite some time.

Have these estimates come to fruition?

Forward P/E is a poor indicator of value and often incorrect.

Investors have terrible long-term memories.

Last Friday was another banner day for the stock market. A positive July jobs report beat estimates and sent the indices soaring into the stratosphere. Both the S&P 500 (NYSEARCA:SPY) and NASDAQ (NASDAQ:QQQ) closed at all-time highs, while the Dow Jones Industrial Average (NYSEARCA:DIA) closed a mere 0.42% from its all-time high.

Party like it's 1999!

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This bull market has turned into a party bus, and the party just won't stop. No matter what happens, Mr. Market has decided to take it as good news. Even when earnings data is terrible, that amounts to good news these days because it lessens the chance for a rate hike, right?

Earnings Calamity

Back in April, I wrote an article titled Mr. Market Has Lost His Mind. When doing my research for that article, I downloaded the current S&P 500 earnings estimates [link initiates download of .xls file] directly from spindices.com. Comparing a copy of the spreadsheet detailing forward earnings estimates from April 21, 2016, with the current earnings estimates, dated July 29, 2016 — my, my, my, how things have changed in a mere 3 months. Below is the direct comparison between spreadsheets:

SP Industries Estimates on 4/21/2016 SP Industries Estimates on 7/29/2016
Estimates As Reported EPS (estimate) As Reported P/E (estimate) 12-Mo As Reported EPS (estimate) As Reported EPS (estimate) As Reported P/E (estimate) 12-Mo As Reported EPS (estimate) Actual Reported EPS
12/31/2017 $33.34 16.71 $125.17 $33.29 17.62 $123.36 ??
9/30/2017 $32.44 17.26 $121.16 $31.65 18.24 $119.14 ??
6/30/2017 $30.93 17.73 $117.98 $30.16 18.90 $115.00 ??
3/31/2017 $28.46 18.43 $113.50 $28.26 19.95 $108.94 ??
12/31/2016 $29.33 19.30 $108.38 $29.06 21.23 $102.39 ??
09/30/2016 $29.25 21.40 $97.75 $27.52 23.62 $92.03 ??
06/30/2016 $26.46 22.80 $91.72 $24.09 24.77 $87.73 ??
03/31/2016 $23.34 23.75 $88.06 N/A N/A N/A $21.72
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These data sets are critical, because the justification for prices we are paying today for the broader indices is based on the "As Reported EPS estimate" for the future - we are paying for assumed earnings growth. And how exactly have those earnings estimates panned out? We discuss this in detail below.

Q1 2016

In April, the forward as-reported earnings of the S&P 500 were estimated to be $23.34. Q1 earnings have long since been finalized, and the real as-reported earnings turned out to be $21.72, 7.5% below estimates. This is a very significant miss - in terms of 30-year returns, the long-term investor can only hope to see their wealth compound at 7-8% per annum. Investing in the S&P 500 in Q1 was based on earnings that never came close to fruition. In one quarter, you cost yourself an entire year's worth of returns if you trusted the estimates from S&P Dow Jones Indices LLC and bought in at those assumed valuations. That is critical to the long-term effects of compounding.

More Forward P/E Lies

Back in Q1, the stock market appeared to be very overvalued. The S&P 500 was trading at a fat 23.75x earnings. But never fear! We are actually getting a pretty fair deal if we all just ignore the present and look to the forward earnings in the reports.

As Reported P/E (estimate) - 4/21/2016
16.71
17.26
17.73
18.43
19.30
21.40
22.80
23.75
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We were told that if we just look a little more than a year out, we'll find we're purchasing the S&P 500 today at a forward P/E of 16.71x. The S&P 500, historically speaking, is considered to be "fair value" when it trades around a 15x P/E, so we're getting the S&P 500 for a fair price if we just look a little bit into the future. Right?

Wrong.

In a mere 3 months, the S&P 500's earnings has seen significant downward revision.

Estimates As Reported EPS (estimate) 4/21/2016 As Reported EPS (estimate) 7/29/2016 % Revision
12/31/2017 $33.34 $33.29 -0.17%
9/30/2017 $32.44 $31.65 -2.42%
6/30/2017 $30.93 $30.16 -2.51%
3/31/2017 $28.46 $28.26 -0.68%
12/31/2016 $29.33 $29.06 -0.92%
09/30/2016 $29.25 $27.52 -5.94%
06/30/2016 $26.46 $24.09 -8.93%
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S&P 500 quarterly estimates have been slashed across the board.

On April 21, the S&P 500 closed at 2,091.48. That means if we purchased the S&P 500 at that price based on the newly-revised data, our P/E at the time of purchase becomes significantly higher across the board.

Estimates 12-Mo As Reported EPS (estimate) 4/21/16 P/E Based on 2,091.48 closing price 4/21/16 12-Mo As Reported EPS (estimate) 7/29/16 P/E Based on 2,091.48 closing price 7/29/16 % P/E Overpaid
12/31/2017 (est) $125.17 16.71 $123.36 16.95 +1.47%
9/30/2017 (est) $121.16 17.26 $119.14 17.56 +1.70%
6/30/2017 (est) $117.98 17.73 $115.00 18.19 +2.59%
3/31/2017 (est) $113.50 18.43 $108.94 19.20 +4.19%
12/31/2016 (est) $108.38 19.30 $102.39 20.43 +5.85%
09/30/2016 (est) $97.75 21.40 $92.03 22.73 +6.21%
06/30/2016 (est) $91.72 22.80 $87.73 23.84 +4.54%
03/31/2016 (est) $88.06 23.75 $86.44 24.20 +1.87%
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The "% P/E Overpaid" column represents the premium you overpaid for the S&P 500 if you bought the index at 2,091.48 based on the Forward P/E forecast on April 21, 2016, versus today's current revised estimates. In other words, you got burnt believing in someone's crystal ball.

But Wait! There's More!

Even worse still, the 2017 P/E estimates have been revised strongly upward in this current earnings estimate report.

Estimates As Reported P/E (estimate) 4/21/2016 As Reported P/E (estimate) 7/29/2016 % Difference
12/31/2017 16.71 17.62 +5.45%
9/30/2017 17.26 18.24 +5.69%
6/30/2017 17.73 18.90 +6.62%
3/31/2017 18.43 19.95 +8.28%
12/31/2016 19.30 21.23 +10.00%
09/30/2016 21.40 23.62 +10.38%
06/30/2016 22.80 24.77 +8.64%
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Just look at that multiple expansion, ladies and gentlemen. In the span of a single quarter, we took a monster haircut on valuation equivalent to a good economic year's typical return.

This Time It's Different!

So here we are, back in an even worse position this quarter than we were in the last quarter. Earnings are being revised downwards and the 2Q2016 earnings calls have been mostly bad news. Yet the stock market continues to hit new highs. We are now trading at a ttm P/E of 25.25x!

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And what exactly is the justification? Well, I guess the 4Q2017 P/E of 17.62x is now supposed to be a good deal given we seem to be stuck in a perpetual 0% interest rate environment? Am I just supposed to believe that they got the earnings estimates correct this time and it won't be revised hugely downward each quarter moving forward again and again?

I try and end my articles with an honest disclosure: I am bearish on market valuations, but I am not short anything. I don't short. It is not my style. I am strictly a long-term shareholder as I do not believe in the concept of unlimited downside for a capped return. The bulk of my portfolio is tied in up index funds, specifically the S&P 500, and I do not intend on selling a single dime.

I am 30 years old. If the net asset value of my portfolio gets wiped out by 50% due to an extreme market correction, recession or depression, I will not lose any sleep over it. In fact, I would be excited, reduce my lifestyle and double-down on buy-ins. I do, however, urge extreme caution for those buying in at these valuations. We are treading on dangerous grounds - if you are buying in due to the promises of forward P/E, do not believe you are getting a good deal based on these estimates. They are blind guesses that mean little as proven by recent history.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.