Equity Benchmark: A Climb Too High

Includes: DIA, QQQ, SPY
by: TraderMark

This from Bloomberg: U.S. Stocks at 25.8 Times Profit Means Rally May End

Ouch. That can't be good.

The irony is, the expensive stocks are being bid up on hopes that their low earnings will improve in the future, whereas the cheap stocks are being sold relentlessly because of fears their earnings will degrade in the future. I am more of a fan of future earnings than of trailing earnings, since the past is the past, but it's an interesting story nonetheless. Traditionally the market will trade at around 14-16x earnings, so one could argue we are almost 80% overvalued.

If ... I repeat, if you believe the economic recovery (not that there was ever a downturn, I mean we just printed a 3.3% GDP quarter!) begins very early in 2009, then you can ignore the valuation and say this is "trough" earnings and the forward earnings will be much higher, and thus the market is "cheap" on forward earnings.

However, that was the same thesis for the '2nd half of 2008' back in the early part of the year ('yes the market is expensive but based on our projections for 2nd half 2008 the market is cheap'). I said that was a fantasy and it would be proven once we got "there" (here). Remember, back "then" they were predicting 60%+ year over year earnings growth in the fourth quarter of 2008 versus fourth quarter of 2007.

So now we are here, and many of those earnings are being slashed (for the 3rd quarter, but they still cling to hope for the 4th quarter) and now they are kicking the can into 2009 and using the same logic - i.e. the market is cheap if you look forward 6 months. I suppose we can do this over and over, and keep saying things are fine because in 6 months earnings will rebound. One day the pundits will even be correct.

We still live in denial. The US market rallies as the rest of the world drops on the belief "we will rebound first." So decoupling does not work on the way down, but it will work on the way up? We will somehow decouple from the rest of the world, despite having the worst of the issues (housing, credit, bailouts, federal budget deficits, consumers with 0% savings rate?) and rebound while the rest of the world suffers? Denial.

From the Bloomberg article (my comments in parens and ital):

  • Since mid July the S&P 500 has gained 4.4 per cent. In contrast, MSCI’s EAFE index, covering the developed world outside the US, is down 3 per cent and its emerging markets index is down 8.3 per cent. So this rally saw the US gain at the rest of the world’s expense.
  • The best already may be over for the U.S. stock market this year. The Standard & Poor's 500 Index, which had the worst first half since 2002, added 0.2 percent this quarter, the only gain among the world's 10 biggest markets in dollar terms. Shares in the benchmark index for American equity climbed to an average 25.8 times reported profits, the highest valuation in five years. The last time that happened, the S&P 500 fell 38 percent.
  • Wall Street forecasters, who were too optimistic about earnings for the past four quarters, predict income at America's biggest companies will grow by a record 62 percent in the final three months of 2008, according to data compiled by S&P. (So in a housing slump, credit contraction, consumer retraction economy - we will have record earnings growth next quarter? Got it - Kool Aid time.)
  • "The market is pricing in the expectation of a good quarter, but we just don't see it,'' said Philip Orlando, who helps manage $350 billion as chief equity market strategist at Federated in New York. "The fundamentals are going to be poor, earnings are going to be bad, and there are going to be more huge writedowns. We think stocks probably need to work 5 to 10 percent lower over the next month or two.''
  • Analyst estimates were at least 26 percentage points too high since the fourth quarter of 2007 as they failed to anticipate more than $500 billion of subprime-related bank losses and a slowing economy, according to data compiled by S&P and Bloomberg. (Missed it by THAT much.)
  • A combination of rising prices and falling earnings caused S&P 500 valuations to surge more than 20 percent this quarter, the biggest increase of any major market, making them the most expensive since November 2003. (Remember, this is all based on the theme that as the world devolves into chaos and anarchy, the U.S. will rebound first and carry the torch - I doubt that very much - I believe the rest of the world will need to rebound and pull us out of the muck. Remember, we are the nexus of all the problems in the first place - how the heck are we going to lead anything?)
  • The index's price-earnings ratio rose above 25 three times in the last five decades, data compiled by Bloomberg show. The last was in 2001, during the bear market that followed the bursting of the dot-com bubble. The increase in valuations preceded a plunge that helped erase about half the market value of U.S. companies. (So we're at a level only reached 3x times in 50 years - that's not good.)
  • S&P 500 companies will report aggregate earnings of $21.69 a share in the current quarter, a gain of 3.9 percent from a year ago, and $24.62 a share in the final three months of 2008, 62 percent higher than last year's fourth quarter, based on projections compiled by S&P. (Kool Aid.)
  • "The U.S. economy, while not strong, has a greater visibility of the bottom,'' said Gayle, the Richmond, Virginia- based chief investment strategist at RidgeWorth, which oversees $70 billion and went "overweight'' U.S. stocks a month ago. Outside the U.S., "the risk factor in the earnings estimates is a little higher than you might see on Wall Street.''
  • Should analysts overstate profits in the second half by the degree they did last quarter, earnings for S&P 500 companies will fall to about $72.17 a share. That would be below the level of 2005, when the S&P 500 was on average 5.9 percent lower than today. The U.S. economy won't support the earnings analysts predict, said Walter ``Bucky'' Hellwig, who oversees $30 billion at Morgan Asset Management in Birmingham, Alabama.
  • The most bullish profit forecasts are for U.S. financial companies. In the fourth quarter, brokerages and insurers will boost earnings almost fivefold from a year ago, analysts say. (Gosh... cmon now - don't we ever learn?) "I don't believe we're through this credit crunch,'' said Stephen Wood, New York-based senior portfolio strategist at Russell Investments, which oversees $213 billion. "Credit portfolios are beginning to deteriorate. Financials will continue to exert downward pressure on earnings for the balance of 2009.''
  • Michael Steinhardt, who returned an average 24 percent a year for almost three decades when he ran his New York-based hedge fund Steinhardt Management Co. (wow), said forecasts for an earnings rebound are a false hope. "My intuition is that they are too early,'' he said. "In an ordinary cycle, this should be the time to start thinking about buying. This isn't an ordinary cycle.'' (Bingo - this is what I keep saying. Most of today's 20/30/40 year old trader types only know the company led recessions of early 00s and early 90s - they don't remember, nor bother to read, about what a consumer led recession - 1970s and early 80s - looks like or how it works - so they are constantly buying "anticipating" the bounce that keeps failing them. And they continue to do so - as they have done much of the past year - not only a consumer led recession for the first time in 3 decades but one with a historic debt bubble and housing depression? And that will all get fixed in a span of 15 months?)

Had not heard of Steinhardt before but 24% annualized over nearly 3 decades is great - he ended his career in '95 so it was a different era than the current 10 years of "Lost Decade" (0% gains in the S&P over past decade) but still interesting. More info on him here. And here.