Same Old, Same Old

Does this sound familiar?

  • The market has a scary two week decline.  Everyone panics and sentiment becomes very bearish.
  • The market rips higher on light volume.

Yes, it is 2009 all over again. 

Last week was the lightest volume week of the year.  NYSE Composite volume on Friday was the forth lightest of the year. Thursday was the second lightest.  Tuesday was the sixth lightest. 

One difference comparing now to last year is that the market is no longer supported by valuation.  In fact, the market is partying like it is 2007 all over again.

Sales per share on the S&P 500 at the end of 2009 was $895.  Analysts are forecasting operating earnings per share of $75 in 2010 and $92 in 2011.  The market is trading at 14.7x 2010 operating earnings, and 12x 2011 earnings.  Excluding financials, the market is trading at 16.7x this year’s earnings and 14.5x next year’s earnings.  Moreover, the PE of the median stock in the S&P 500 is trading at 16.7x and 14.8x respectively.

That is not cheap.  It is not particularly expensive from a historical perspective either, but given the problems in the economy, stocks are not a bargain.

Let us look at the assumptions for analysts’ bottom-up earnings forecasts.  Historically, the profit margin for companies in the S&P 500 has been 5.5%, 6.5% if one imagines away all the charge-offs, aka "operating earnings." 

Assuming nominal growth of the economy is 6% (3% real GDP + 3% inflation), sales per share for the S&P 500 will be $953 in 2010 and $1011 in 2011.  With estimates for this and next year at $75 and $92 respectively, analysts’ assumptions imply profit margins of 7.9% and 9.1%, well above average.  Estimates for 2011 imply that, other than for 18 months earlier in the decade and for a brief period in the 1960s, companies will be more profitable than at any time in history.

Perhaps this will be the case, but I am skeptical.

Wall Street consistently over-estimates the true profitability of corporate America.  Over the past two decades, operating earnings have been on average 20% higher than reported earnings.  If one excludes the tech and the housing bubbles, operating earnings have been on average 11% higher. 

Let us be generous to Wall Street and assume that the analysts are over-estimating corporate profitability by only 11%.  If so, even using Wall Street’s assumptions, the market is trading at 16.2x this year and 13.2x next year.  Assuming that Wall Street is over-estimating real earnings by 15%, as it did before the housing bubble, stocks are trading at 16.9x and 13.8x respectively.

I believe that we are in a period of higher profitability for corporations, but not as high as Wall Street is implying.  My “normalized” profit margin is 7%.  Whether or not this is correct, I have no idea, but it seems reasonable to me.  If so, the market is trading at 16.6x this year’s earnings.

Do all these numbers mean anything for this year’s stock market returns?  No, of course not!  Valuation means almost nothing in any given year.  Markets can and will do anything they please.  In this liquidity-driven market, fundamentals mean less than ever.  Do not be surprised if markets move higher in the near-term.

However, long-term returns are driven solely by fundamentals and the price one pays for those fundamentals.  Given current valuations, and that economic growth is likely to be relatively tepid over the next several years, I expect returns from stocks will be as well.

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