Wall Street's New Math

Includes: AIG, C, GE, JPM, MSFT, XOM
by: Tsachy Mishal

There is a new type of math circulating around Wall Street. It involves taking the current earnings of the S&P 500 and applying a single digit P/E ratio to it. The result is lower and lower price targets for the S&P 500. This is the polar opposite of the internet bubble where as stocks rose higher, price targets were raised.

The logic being used in this exercise is flawed. For instance, AIG (NYSE:AIG) is scheduled to report a 60 billion dollar loss on Monday. The combined yearly profits of ExxonMobil (NYSE:XOM) and Microsoft (NASDAQ:MSFT) are 60 billion dollars. If you combine the three companies together they have no profits. Applying an 8 multiple to them yields a price of zero for the three companies. Are Microsoft and Exxon worth nothing because AIG reported a huge loss?

The same people that were saying stocks were cheap a year and a half ago because the forward P/E was cheap, are now saying the market is expensive at half the price. The only way to have a consistent benchmark is to normalize earnings. By applying a normalized profit margin, the market would have looked very expensive a year and a half ago and cheap today.

Why normalize profit margins? Profit margins are the most mean reverting series in capitalism. If there are high margins in a business more people are attracted to it and margins tend to decrease. If there are low margins people leave the business and margins tend to increase. Over the long term, profit margins of the S&P 500 have reverted to the mean. A year and a half ago profit margins were inflated by the expansion and use of leverage. Today, they are being depressed by the contraction and deleveraging.

A year ago everyone was looking at operating earnings, while now people want to look at GAAP earnings including writedowns. The problem is that one can always find a benchmark that will agree with their gut. Most who have invested long enough will realize that their gut is usually wrong.

On Friday, super bear Robert Prechter of Elliot Wave theory was on CNBC saying that he believed we were in the fifth and final wave down of this market decline. While I know nothing about Elliot Wave theory, I agree with him that this is the final wave down but for a different reason.

People are finally accepting that there is not an easy fix for this crisis. For the past year their were cries about "doing something". As if the government had a magic wand that could fix problems in one day that have been building up for decades. Hard decsions are finally being made. GE (NYSE:GE) and JPMorgan (NYSE:JPM) finally cut their dividend and Citigroup (NYSE:C) is reducing debt by converting preferred shares into common equity. While the bear market likely has more damage to do, I believe we are getting late in the game.

To all those who insist on a single digit P/E ratio, there are literally hundreds of stocks that meet that criteria, including high quality companies. However, I doubt those people really want to buy stocks at single digit P/E ratios. They are just looking for an excuse to follow their trusty gut.