Tag Archives: bear markets

The reality of S&P 500 earnings

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To say that stocks are anything other than dangerously overpriced with a P/E of over 130 and a yield of 2.5% on unsustainable dividends is either farcical or fraudulent.

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For such a simple little metric, the P/E ratio is subjected to all kinds of perversions to deflate it to levels that can be passed off as reflecting value. At the very least, most bubbleheads try to make it less scary than its current level of 133 for the S&P 500.

Do-it-yourself P/E and dividend analysis

It is very easy to find out what the real index PE is at any given time. Just google S&P 500 earnings, and right at the top you will see a link to an Excel file on S&P’s website. Download it and see the data for yourself. The file provides 20 years of history on operating earnings, “as reported” (net) earnings, and cash dividends for the benchmark big-cap index.  Here is a permalink to the latest Excel file.

When talking P/E ratios, look at “as reported earnings,” which are the real bottom line, or as close as today’s accounting methods get to it. “Operating earnings” are all the rage these days with the sell-side and CNBC crowd, since they of course are higher, as they don’t include pesky items like depreciation, taxes and interest. Even more ridiculous is the use of “forward operating earnings,” which are not an accounting entry at all, but just what Wall Street analysts are telling the public that companies might report in future quarters and fiscal years.

To get the real P/E, the one that has been used as a gauge of value for decades, take the sum of the last four quarters of “as reported earnings”. Through Q1 09, for which 99% of companies have now reported, the index has earned a 12-month total of $6.87 (with the index at 915, the P/E is 133).

An S&P analyst has noted in the file that if Q3 comes in as expected, trailing 12-month earnings will be negative for the first time in history (I bet CNBC will decide to ignore that little factoid, since it’ll be a hard one to spin). Earnings are down from an all-time 12-month peak of $84.95 as of Q2 2007. To be fair to the bulls, the current figures include a loss of $23 in Q4 2008, when financial companies took their write-downs, though surely more of the same are on the way, and not just for banks.

Today’s earnings vs. recent history

Q1 2009 earnings were about $7.53, and Q2 and Q3 are expected (analysts tend not to be that far off for quarters directly ahead) to be more or less the same, so we are on pace for about $30 in annualized earnings. A glace at the historical data shows that this is about the same level as in 2001-2003, after a peak of $48-54 for a few quarters in 1999 and 2000. You have to go back to 1994-1995 to again see the $30 level, with the $20 level about the norm from 1988-1993. Assuming that the $30 is sustained, you could say that the current P/E is 30. That’s not value in anyone’s book.

Dividends from la-la land

One particularly striking fact in this data is that 12-month dividends have hardly budged from record levels, coming in at $27.25 as of Q1 2009. Dividends had been growing fairly moderately and steadily from 1988 to 2005, increasing from the $9 to $20 level over 17 years. At the height of the credit binge, companies were flush with cash to give away and buy back stock at inflated prices, rather than pay down the debt they took on to generate those temporary earnings. That they are continuing to pay these high dividends says to me that managers are in total denial or are playing charades to maintain the illusion of health.

The index only yields about 2.5% on current dividends, but if dividends fall back to just 2004 levels, the yield would fall under 2% if the index still trades at 900. Keep in mind that secular bear markets bottom by enticing with high cash yields, as investors by then are too pessimistic to expect much in the way of capital gains. At the 1930s and 1970s bottoms, the market yielded over 10% and 7%, respectively. Just a 5% yield on 2005-level earnings ($20) would be the 400 level on the index. A 7% yield on 1998 yields would mean the index trades under 250.

Whether you are a deflationist or inflationist, you have to admit that a strong dose of either would not be kind to equity valuations. In the ’70s, people demanded high current yields because future yields were so heavily discounted by inflation, and in the ’30s, stock valuations became extremely depressed as earnings tanked and investors panicked.

A crude indication of solid stock values is when the S&P 500 yields over 5% and the P/E is under 10. Stocks can get cheaper than that, but at those levels you really can buy for the long run. To say that stocks are anything other than dangerously overpriced with a P/E of over 130 and a yield of 2.5% on unsustainable dividends is either farcical or fraudulent.

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Addendum:

For reference, here is a link to S&P500 earnings and dividend data going back to 1960.

Glancing at the typical ratio of earnings to dividends, if the index is earning $30, one should expect dividends to be about $10-20. There is no record here of another time when dividends were higher than earnings, as they are at present. This says to me that the sustainable yield today is not even 2.5%, but more like 1% to 1.5%, comparable to the peak of the peak dot-com bubble.

From this level of overvaluation in the face of declining fundamentals, stocks could fall hard for another 18 months to restore value fast (1929-1932 model), in which case the 200 level is likely by 2011.  Another outcome is to trade in a range for a decade or more and wait and hope for a bout of moderate inflation to increase the nominal bottom line (1968-1982 model). A third possibility is the Japanese model, where the S&P would get to 200, but over 20+ years. Long-time readers know that as a deflationist and Elliott waver I expect the first outcome, with the most stunning phase of the bear market soon to come.

How low can stocks go? The polite version.

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News flash: Stocks can go down.

Funny how people forget these things. It just goes to show how market prices are at least as much about psychology as fundamentals.

At their core, stocks represent two things: a claim on any future earnings that might be generated, and a company’s net assets. These values are both dependent on people’s sentiments about the future, which swing from optimism to pessimism over time scales as small as an hour or as long as several decades.

Earnings and asset prices are highly variable, especially when debt is employed as liberally as it has been lately. Debt overload destroys economies, because it creates massive distortions in asset prices and risk perception. The boom phase is the destructive phase, because those distortions result in waste. The bust is simply taking an honest accounting of that waste, and it cannot be stopped, and should not be fought, because it restores sanity in the form of market-clearing prices.

Leverage works both ways.

Busts destroy both earnings and net asset values. As asset values drop, leverage increases the destruction of equity.  Lehman, Bear Stearns and others were levered 30:1, so their equity went POOF with just a 3% decrease in asset prices. A retail margin stock account can be levered 3:1, so if somebody put it all into Apple at 180 in August, they would have been wiped out by last week.

Recently, even big industrial firms have levered up so that they could grow-grow-grow and vest those stock options. In the bust, their earnings and asset values (real estate, equipment, subsidiaries) drop, but the debt doesn’t go away. It should therefore come as no surprise that equity values routinely drop by 75% or more in bear markets, but it always does, because each generation has to make its own mistakes.

By the numbers.

Here’s a little back of the envelope calculation I use to sober up the buy-and-holders:

Everyone knows about PEs. For the market as a whole, 10 is pretty cheap, and 20 is pretty expensive. Now, PEs are not everything, since you have to look at the earnings cycle, too. A lot of big gold miners had very high or infinite PEs when the metal was under $300, but they were still a great buy. Lehman and Bear Stearns had PEs last year of about 10.

Earnings for the market as a whole are very volatile. (S&P publishes historical data here — big Excel file available.) Forget about “operating earnings.” I believe it was Charlie Munger, the Berkshire partner who has not turned communist in his old age, who said that every time you hear operating earnings, you should substitute the phrase “bullshit earnings.” What you want are real, reported earnings. PEs should be based on the last year’s bottom line, not what a bunch of ass-kissing analysts are told to tell you they think this year’s or next year’s earnings will be.

So, if we are in a real recession and a real bear market (by the way, real bear markets last at least three years), what does that mean for earnings and PEs?

For this discussion I prefer to use the S&P 500, since it is a broad index with copious data available:

S&P 500 earnings peaked about about $80 for the index in 2006, up from a little trough of $44 in 2001. The index peaked last year a bit north of 1550, for a PE on peak (real trailing) earnings of just under 20. Pretty darned rich when you consider that earnings were about to fall off a cliff, though the aforementioned cheerleaders kept telling us how cheap stocks were at the time.

According to S&P, the first two quarters of 2008 have come in with earnings of about $15.50 and $13.20, respectively, for an annualized rate of something like $57. Apply today’s S&P 500 closing price of 1106 and you see that we are on track for a PE of 19.4 if earnings stay steady from here.

But real bear markets end with PEs under 10. In bear markets, social mood becomes more pessimistic and people have less faith in future earnings. The multiple hovered around 8 in the doldrums of the late 1970s and early 1980s, and bottomed at about 7 in 1932. Let’s be nice and apply a PE of 10 to today’s $57 in somewhat bullshit forward earnings: that of course would give us 570 on the S&P, a drop of over 60% from last October (this would correspond to about 5000 on the Dow).

Think earnings will be even worse next year than in the little 2001-2002 recession? Well, better revise those figures accordingly. I personally assume at least a 50% drop in earnings from 2006 and a PE under 10, for a Dow somewhere under 3500. That is, if all goes well.

Bear markets happen. It’s the stock market, people.

You see, it’s no big deal for stock markets to fall by well over 50%, if not 90%. It’s just big deal for Americans, because they have been lulled into complacency by a 26-year bull market. They should have been saving more all these years, and in a more reliable form than the stock market. Too bad their great-grandparents weren’t around to warn them.

Real bear markets last at least three years

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Is this a bear market? Are we in a recession? Let’s assume everyone can finally agree on those points. In that case, nobody should be looking for a bottom for at least another two years.

This is not 1987, nor 1998, nor 2004. Those short-term corrections did not entail full-blown global recessions and debt liquidations. They were mere technical blips, statistical noise to anyone but short-term traders. Today, with the credit markets frozen, home prices down worldwide, unemployment taking off, weekly bank failures, and corporate bankruptcies left and right, we can be pretty sure that there are some real reasons for the global decline in stock prices.

Historical precedents

The aftermath of a society-wide credit binge and speculative mania across all asset classes is best compared to the Great Depression of the 1930s, the earlier depression of the 1830s and ’40s, or the bursting of the South Seas and Mississippi bubbles in the early 1700s. Those respective bear markets lasted roughly 3, 6 and 60 years, so given the circumstances, we should hope for another quick and dirty depression like the 1930s. The most recent run-of-the-mill bear market, the dot-com bust, lasted from March 2000 to October 2002, a mere 31 months, and it was associated with only the mildest of recessions. Prior to that, we had the entire recession-filled period from 1966 to 1982, when the Dow swung wildly in a range for 16 years while inflation raged, resulting in a 75% real loss.

If you measure its age from the nominal peak, the current bear is all of 11 months old, an adolescent or young adult. I actually prefer to think of this as just the next phase down in the bear that started in 2000, since if you measure your assets in gold or a basket of currencies, US stocks never came close to regaining those highs. But then, I think the West is in for a long decline in standard of living, so even 8 years is early in this bear. It takes generations for a society to relearn the lessons of prudence, personal responsibility and laissez-faire that are necessary for sustained growth. Just ask the Chinese.

Here’s a century of the Dow in gold. Look like a bottom yet?

Click chart for sharper view. Source: chartsrus.com

Panic, hope, repeat

On a month-to-month scale, bear markets alternate between periods of panic and hope, appearing on a chart as a series of waterfalls and dead-cat bounces. We have been through two of each since October 2007, and the bounce out of the July lows appears to be rolling over, likely into the deepest sell-off yet (Dow 9000 by Christmas?). Early in the game as it is, after this plunge to new lows, the bottom-callers will emerge and the shorts will scramble to cover, and we could have a mighty rally, maybe 25% over several months, which would just serve to further demoralize buyers during the next leg down.

Real bottoms are lonely

When the bottom-calling stops and the market doesn’t snap back up from a plunge, but just drifts along in a climate of disgust with little volume or public interest, it will be time to think about going long again.

300 Point Rallies are Characteristic of Bear Markets

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Credit to Merrill’s David Rosenberg for this little factoid:

The Dow surged 331 points – moves like that typically take place in bear markets.
See the table below – there have been six of these sessions since the bear
market began a year ago; there were absolutely none in the 2002-07 bull market.

The markets just get more volatile in a bear trend, with big swings both ways. The 2000-2002 bear market saw three separate rallies of 20% or more, with each one rolling over into a spectacular waterfall:


Click image for sharper view. Source: Yahoo! Finance

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