Why the Bear Is Alive and Well: P/E

A column in the Sunday NYT purports to look at Why the Bear Is Alive and Well. While the main thrust of the column is on point — namely, stocks remain too expensive for a true bear market bottom — I have one small issue. It revives a meme that won’t die — namely, that Earnings ex-Financials are pretty good:

"Corporate earnings were being distorted by troubles in just one sector: the financials. According to S.& P., earnings for financial companies are expected to drop about 70 percent this year versus 2007. That accounts for most of the profit drop for the overall market…

Jeffrey N. Kleintop, chief market strategist at LPL Financial in Boston, also noted that based on “forward earnings” — projected profits, as opposed to actual results — the market P/E is already quite modest. Consensus earnings forecasts from Wall Street analysts for 2009 work out to a forward P/E of around 12 for the S.& P. 500."

As we have shown over the years, relying on Wall Street’s forward earnings is a formula for losing money — lots of it. Indeed, relying on nearly anything out of Wall Street is a suspect strategy. Better to cherry pick the best of what the street produces, and ignore the vast majority of what has been shown to be conflicted, self interested, compromised junk.

Rather than spin earnings to justify a long and wrong position, let’s consider a variety of factors and scenarios. Think about these 3 mind experiments:

• What are the S&P500 earnings currently if we back out the 3 largest oil companies? (ex oil, they are down 30%)

• What would SPX P/E have been over the past 5 years, when the P/E was artificially lowered due to earnings we now know were based on imprudent speculation by all of the financials? (Much higher)

• If we remove the upside and downside outliers — Energy & Financials — what have the SPX P/E ratio been for the past 4 quarters? (mediocre and overstated by Wall Street)

My point? Merely taking away the negative results caused by reckless speculation by irresponsible management informs us of nothing. What do you learn if I show you that during my  youthful baseball career, I was a .600 hitter? Oh, I have to add that number is, of course, ex-strikeouts . . . 

Well, at least our boy Rosenberg gets it right:

"Of course, Wall Street earnings projections have been way too optimistic in recent quarters, and David A. Rosenberg, the Merrill Lynch economist, thinks that they may still be too rosy. In a recent economic commentary, he says Merrill is expecting S.& P. 500 earnings to continue to decline through 2009. In fact, he says he thinks profits of the S.& P. index will come in at around $63 a share next year. That’s down from the $68 he is forecasting for this year, and a far cry from the $100 that Wall Street is expecting for 2009. Using his projection, the market’s forward P/E would be nearly 20, not 13. If he’s right about earnings, it may be a while before a new bull can emerge.

I am currently forecasting $65 SPX earnings, and a 15 PE gets you to about 975. There is a significant chance I revise this lower in the coming quarters; I have seen respectable forecasts of $57, and some as low as $48. It all depends upon how deep and prolonged the current recession will be . . .

>

Previously:
Analysts Overstate Earnings Once Again (July 30, 2008)
http://bigpicture.typepad.com/comments/2008/07/analysts-overst.html

S&P500 Profits Ex 3 Oil Cos = Awful (May 19, 2008) 
http://bigpicture.typepad.com/comments/2008/05/sp500-ex-energy.html

S&P500 ex-Risk ? (November 06, 2007)   
http://bigpicture.typepad.com/comments/2007/11/sp500-ex-risk.html

Source:
Why the Bear Is Alive and Well
PAUL J. LIM
NYT, September 6, 2008
http://www.nytimes.com/2008/09/07/business/yourmoney/07fund.html

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  1. SINGER commented on Sep 7

    In other words, it’s gonna get ugly!!!

    It’s funny that people rely on projected earnings when 1) the past projections have been horribly wrong and 2) it is a fact of life that you can’t predict the future…

  2. JustinTheSkeptic commented on Sep 7

    How deep = number of years it takes to get millions of construction workers, working in other industries, because we are not going to see the kind of building around the country, not just in the sun-belt states, in a long long time. And now that they are going to try and support it with this latest bail-out. Oh my! A slow steady departure into hell.

  3. Bruce commented on Sep 7

    Well, Barry, I am afraid I can’t see exactly where we head from here..

    One of the guys in Minyanville says the reason things are often confused, that there is a fog of war, is that events like these occur non-linearly, not easily seen, but that memory of these events in the future is linear…like c followed b followed a…

    I don’t see why the bear market shouldn’t continue…but I don’t see why anyone would want to own the USDollar…all Uncle Same is doing is still creating more debt for the taxpayer, but now at a much, much increased rate…plus decreasing tax revenues to state and other governments, costs of two active wars, etc…

    The government has not announced they will be cutting back on any other programs to fund the GSE bailouts, so expenses will keep racheting up.

    Yet, it seems to me that once the chickens come home to roost, as they have, you probably don’t have the ability to reinflate…it looks to me here that globally we are entering a slowdown that must run its course..if we were the only country involved maybe we end up with hyperinflation, but I don’t see that here.

    Oh, well…

    Bruce in Tennessee

  4. Jim Haygood commented on Sep 7

    “Relying on nearly anything out of Wall Street is a suspect strategy. Better to cherry pick the best of what the street produces, and ignore the vast majority of what has been shown to be conflicted, self interested, compromised junk.” — Barry R.

    That’s a lifetime’s worth of wisdom in a single paragraph.

    Wall Street also likes to promote the myth that earnings are the major determinant of stock prices. However, P/E ratios are heavily dependent on prevailing inflation and interest rates. For example, S&P earnings were pretty strong in 1974, but the market got crushed by P/E contraction thanks to double-digit inflation.

    The main reason Wall Street analysts focus on earnings is that a pseudo-scientific discipline can be applied to estimate input costs, sales prices, industry capacity, and so forth, to justify an earnings projection. This looks a lot more analytical than simple price targets, which are obviously pulled out of one’s rectum. Yet there is no evidence than analysts are any better at projecting earnings than they are at projecting stock prices, which are of course the key variable for investors.

    I don’t read any Wall Street research. But I’m thankful that Barry wades into the Wall Street septic tank in his toxic spill suit to extract a few diamonds from the reeking sea of crapulent disinformation.

  5. pjfny commented on Sep 7

    If you look at trailing gaap earnings (to compare to history) and not operating or forward operating earnings, you currently get well above 20 PE…..long term average of trailing gaap is about 15 pe…..for us to have a long term average of 15, it has to be well below 15 some of the time…..10 times $65 in earnings is 650 on the spx

    I rest my case!

  6. godot10 commented on Sep 7

    //How deep = number of years it takes to get millions of construction workers, working in other industries, because we are not going to see the kind of building around the country, not just in the sun-belt states, in a long long time. And now that they are going to try and support it with this latest bail-out. Oh my! A slow steady departure into hell.//

    The United States needs massive infrastructure investment, just like the BRIC countries. If it forgets about the costly foreign wars and the financial gimmickry of Wall Street, and focuses on (1) renewing the electricity grid (and other basic public infrastructure) (2) building the alternative energy complement to supply 25% of the electricity (mainly wind and solar), (3) new nukes and next generation coal (4) public transit infrastructure for its cities, and (5) high speed intercity passenger rail for the country.

    The ongoing nationalization of the housing industry and related mortgage finance, the bailout of Wall Street (private profits, but losses are socialized), have sort of killed the philosophical arguments about a massive infrastructure push from the federal government in partnership with the states, city, industry, private equity, and sovereign wealth funds.

    It turns out that Wall Street loves socialism and government spending! -).

  7. Riles commented on Sep 7

    So much perspective, and “Investing Wisdom” in “Why the Bear…”! My kids have asked me to write a “booklet” on what have learned from 45 years of active investing. Not sure if even a good idea, but did forward this piece to all, due two points my “booklet” would have highlighted: 1. Cannot put much confidence in anything The Street says, as it is tainted by its own self-interest, 2. “Forward” P/E, is about useless in determing “fair value” of the market, due virtually always overly optimistic, due….#1!

  8. leftback commented on Sep 7

    Sound analysis.. then add the fact that in deep recessions multiples tend to contract also, sometimes as low as P/E = 8 !! All adds up to a big haircut, eh Barry?

    The D train is leaving the station..

  9. Concerned Citizen commented on Sep 7

    Godot10, Under FDR we had massive public works projects, and it helped some, but it wasn’t until we got into WWII, that things really took off. As we sit today we are already in a war, and at the same time have the local, state, and federal tax coffers depleted. So where in does one get ahold of the money to bring on another massive government spending era? When you look at what is going on from afar it just looks awful. Pardon my simplistic view…but it just looks awful. Have we ever been in a situation as dire as this in our country’s history?

  10. Mark commented on Sep 7

    Speaking of the macro earnings outlook:

    We’re all familiar with the old saw “When Detroit catches a cold…,” yes…?

    Well, apparently, it’s not a cold. It’s pneumonia.

    http://www.breitbart.com/article.php?id=080907041331.w5v4edpo&show_article=1

    I don’t think that the gov’t has lately seen an opportunity to inflate that it didn’t like. Any counter-bets on how this one will play out?

  11. Brian commented on Sep 7

    B.R.,

    Recession? Without sounding like a nutcase, We will be lucky if we ONLY have a recession.

    My long term stuff is mostly in cash and has been since last August (no offense BR, I know you are still profitable in this enviroment). But we have been daytrading the heck out of it!!

  12. dblwyo commented on Sep 7

    Marvelous de-bunking job which, alas, is not reflected in any widespread grasp by Mr. Market and his minions. Have to agree with the observations and assessments of most of the rest of the commenters as well. And thanks for sharing your outlook – first time I’ve seen something that stark in print anywhere. But a drop in both earnings and PEs is over-due and well justified by the fundamentals and the economic outlook.
    As my small contribution to the debate let me offer up some charts: http://tinyurl.com/5wlw4w
    They take a look at the relationships between the economy and corporate profits and then the SP500. Profits btw are nose-diving, just not reflected. The point being that it may be non-linear but the turning points are visible with the right instruments on your dashboard. And we have crossed a tipping point IMHO from the charts. The charts also link to the Graham-Dodd valuation formulas so you can see what a conservative but reasonable and well-performing valuation would be going forward by eyeballing the charts.With money at 6% a reasonable forward PE for growth rates of 0,2 & 4% would range from 6-12. OUCH !

  13. leftback commented on Sep 7

    11am presser on the bailout is rumored.. but I have to go to the store for milk.

  14. dapoopa commented on Sep 7

    We are already in a war on several fronts (Iraq/Afghanistan/Pakistan), but it obviously hasn’t been enough to get the economy on a real war footing like in WWII. Hence the view that to jump-start the economy they are seeking to trigger a new Cold War with Russia. If that doesn’t work, then there’s always Iran…

    These are truly dangerous times we are living in…

  15. Joe commented on Sep 7

    You will get your ex-oil, if comparisons are between $140 oil and sub $100 oil next year.

  16. Paul Jones commented on Sep 7

    If permanent socio-economic change were to ever come, what would it look like financially?

    Globalization is raising standards of living across the globe, but not everyone is a winner. The American Middle Class and 1st world laborers are losing big time.

    The 1st World winners, our budding aristocratic class, tried to palliate that loss with Biblical-scale borrowing which they then turned around and loaned to the people to string them along while the jobless prison society was erected around them.

    Well, the People started fighting back the only way they knew how: they stopped paying their bills. Now the Big Wigs are going to leave their creditors around the world holding the bag.

    The era of Globalism is going to take a nasty turn as it did in 1914. Only this time we are armed to the teeth with nukes, resource depleted, and it wont be restricted to the European theater.

    I suggest reading the works of John Foster Dulles, who was part of the American negotiating team at Versailles. You’ll come away with two lessons: 1) international relations can be very predictable and 2) even when you know what is going to happen you can’t do much to avert it.

    The cell based life form called Homo sapiens really doesn’t deviate much from his instinctual programming (e.g. the popularity of Sarah Palin).

  17. Anonymouse commented on Sep 7

    Personally, I would expect earnings to drop far more sharply than expected simply because the credit markets won’t be functioning well enough (poorly?) to facilitate the kind of off-balance sheet machinations that have been used to goose earnings in the past and many of those off-balance sheet bets are going to proven wrong and forced back onto the balance sheet.

  18. Mark E Hoffer commented on Sep 7

    “Globalization is raising standards of living across the globe, but not everyone is a winner. The American Middle Class and 1st world laborers are losing big time.

    The 1st World winners, our budding aristocratic class, tried to palliate that loss with Biblical-scale borrowing which they then turned around and loaned to the people to string them along while the jobless prison society was erected around them.”
    Posted by: Paul Jones | Sep 7, 2008 11:15:36 AM

    “The American Middle Class…are losing big time.”
    “..loaned to the people to string them along while the jobless prison society was erected around them.”

    This is the Fact that people better wake up to..It’s about Control.

    to excerpt a speech given by Patrick Henry:
    “It is in vain, sir, to extenuate the matter. Gentlemen may cry, “Peace! Peace!” — but there is no peace. The war is actually begun! The next gale that sweeps from the north will bring to our ears the clash of resounding arms! Our brethren are already in the field! Why stand we here idle? What is it that gentlemen wish? What would they have? Is life so dear, or peace so sweet, as to be purchased at the price of chains and slavery?”
    http://www.historyplace.com/speeches/henry.htm

    btw, w/ the above excerpt, I hope y’all have, both, your meta-& physics caps on..

  19. MJM commented on Sep 9

    I read this already..not sure where. I suspect you’re reposting rather than plagiarizing… oh!! maybe I read it at seeking alpha. Just kidding. Seriously, reading something twice.. like typing this post is a waste of my time. Take a vacation dude!

  20. dblwyo commented on Sep 9

    Thanks for re-posting this; remember reading it and thinking well of the points first time but had lost track of them but it will be the issue. But can you follow-up with a Part 2 and discuss that $65 please ? S&P is still looking for $80 on their most recently (9/2) updated sector earnings outlooks – presuming you’re talking about full year figures, right ?
    And with that much of a haircut a PE of 15 seems rather high.

  21. bdg123 commented on Sep 9

    That Kleintop guy gives a great interview. He looks like the proverbial deer in the headlights.

    CNBC is beholden to advertising, to Wall Street and corporations. Only a channel with such conflicts of interest would ever put this guy on TV and give him the notoriety such that he would be interviewed for that article. When the public realizes its trust has been misplaced, we shall see financial television struggle for its very existence as it did post 2000. But, this will be worse. Likely ain’t gonna be no more million dollar challenges on CNBC. Ever. How long will any thinly-watched targeted channels last on average? Ten to twenty years? Cable TV has been around quite some time. Is there a targeted niche channel from thirty years ago that is still on today? There is an argument to be made CNBC is generational. If we see ten or more years of zero asset inflation, (I know everyone thinks we are in an inflationary environment but that dog doesn’t hunt) there are reasonable arguments to be made that there ain’t gonna be no CNBC.

  22. CNBC Sucks commented on Sep 9

    This is a serious question: How do you price a moderately deep, historically long recession? I am talking 5 – 10 years. I don’t see any fundamental drivers of real economic growth (such as IT driving growth from the early 1980s through early 2000s), unless we have a national energy strategy (50% probability). Plus, America has a woefully weak balance sheet at public sector and consumer levels (mixed at the corporate level).

    The US may actually be facing 10 – 15 years of poor economic performance, but I am trying to be optimistic here.

  23. Dhukka commented on Sep 9

    Jeff Kleintop, the quintessential bull, does anyone even listen to that fool?

    Jeff Klientop on CNBC – 12/14/2007, the stockmarket has “fully priced in the full extent of any economic slowdown” S&P500 at the time 1468.

    As soon as you here someone mention that the market is cheap based on forward earnigns projections you can just stop listeing straight away, clearly they’re clueless.

    Here’s a summary of how clueless analysts have been over the past 12 months

    http://fundamentalanalyst.blogspot.com/2008/08/analysts-still-playing-catch-up-on.html

  24. craig commented on Sep 9

    Also need to remember recent EPS is from historic high corporate margins that are coming down and likely to continue down….maybe below the long term average of 6%. a lot of market commentators were putting historically high PE multiples on EPS from historic high operating margins. Not very prudent because record high margins don’t last….corporate profit margins is a very mean reverting series over time. So it’s likely that corporate profit margins will get back to or go under the long term avg. So instead of a world where the market is priced on record high profit margins and close to record high PEs, imagine if the market was priced with a historically low PE and with EPS derived from a year or two at avg or below avg profit margins. You’d use like a 12x on EPS of maybe $60 and get an SPX of 720. Ouch. It’s happened before (early 80’s PE was under 10x), but i’m not saying it’s gonna do that again.

  25. DL commented on Sep 9

    A lot of analysts argue that earnings EXCLUDING financials are good (therefore you should buy stocks); they also like to argue that the P/E multiple of the market INCLUDING financials is not that high (therefore you should buy stocks).

  26. Blissex commented on Sep 9

    Also guys, if the CPI/PCE/… whatever understate true inflation, corporate earnings suffer from inflation illusion too.

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