“I have to get into this market; otherwise it’s just dragging on me” (A portfolio manager quoted in the Wall Street Journal just prior to the March 2000 peak in the S&P 500.)
“..as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Citigroup CEO Chuck Prince in July 2007) You know how that turned out.
It’s that time again. The Dow surpassed its all-time high and the S&P 500 is not that far from the tops of 1553 on March 24, 2000 and 1576 on October 9, 2007. Just as in 2000 and 2007, the economic, valuation and political background does not support the budding euphoria.
The economy has been limping along at about a 2% growth rate despite the near-zero percent Fed Funds yield and huge amounts of Fed bond purchases. At the same time fiscal policy has become a significant headwind. The agreement to avert the fiscal cliff could slice about 1% off GDP with the sequester reducing it by another 0.5%. A 1.5% hit to a GDP that was only growing at about 2% leaves the economy on awfully thin ice, and very close to recession. Consumers are still in the process of deleveraging their debt, and with wages climbing so slowly, are in no position to go on a spending spree anytime soon. Businesses, sensing a lack of consumer demand, and worried about the dysfunction in Washington, are not likely to step up capital expenditures to any great degree. Unlike the stock market, they are building up their cash in anticipation of the next crisis.
The market has climbed on the basis of an almost childlike faith in the Fed as well as record corporate profits. As we have previously stated the Fed has not been successful in channeling money into the real economy. Moreover, corporate earnings growth has come to halt and is threatening to turn down. In fact, third quarter S&P 500 operating earnings declined from a year earlier, and fourth quarter reports seem to be falling short as well with the vast majority of companies having already reported. Two quarters of declining year-to-year earnings growth has been seen only in recessionary environments. Earnings for the full year were up a miniscule 0.6% from 2011.
Although earnings estimates have been coming down analysts are still forecasting an increase of 14.7% for 2013 and another 12.8% for 2014. This outcome is highly unlikely, and will probably disappoint on the downside, particularly in view of the decline in fourth quarter productivity. In April 2012 the consensus forecast for 2012 operating earnings was $104.89, and ended up at $96.99. Even the prediction for 2013 has been reduced to $111.28 from $118.85. If anything, the downward revisions appear to be accelerating. Fourth quarter earnings turned out to be 13% lower than forecasts made as late as September. To make matters worse, profit margins are at historical peaks, and whenever this has happened margins have reverted to the mean.
Rosy forward-looking earnings forecasts that come crashing down are nothing new for the market. These forecasts are almost always wrong, and most often on the high side. In mid-2000 the forecast of forward operating earnings was $64 and eventually came in at $38. At year-end 2007 the consensus estimate for 2008 was $89 and remained there until the end of May. Even at the end of October, only two months from year-end, the estimate was $72. The actual number came in at $46 just a few months later. The estimate for 2009 was even more laughable at $110 in May 2008. At year-end it was still $99, but eventually ended up at only $57.
Given all of the problems with using forward operating earnings as a measure of market valuation, it’s amazing that it continues in such widespread use. Currently, a large number of analysts are using the 2013 operating earnings forecast of $113 in estimating the P/E ratio at 13.7, which they regard as reasonable or even slightly undervalued. History, however, indicates that such euphoric forecasts at turning points are often hugely overestimated. When the actual earnings are reported it becomes apparent that the P/E ratio was far higher than it appeared at the time.
We also note that for the purposes of this comment we have gone along with the “Street’s” predominant use of operating earnings. As long-time readers know, we prefer the use of trailing cyclically-smoothed reported (GAAP) earnings, which gives a truer picture of valuation. On this basis the P/E ratio is about 19, which would be highly overvalued for any time before the series of bubbles that started in the late 1990s.