As the US Q4 earnings reporting season kicks off, not only growth will be closely monitored but also the quality of earnings. These aspects will be very strongly on my radar screen over the next few weeks as I believe the intermediate trend of the stock market could take its cue from the state of corporate America.
This brings me to the topic of valuations (at 06:00 in the morning in the transit area of Munich airport!). Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 21.10; using “as reported” (GAAP) earnings the figure is a higher 25.7, but down from the 80+ valuations that characterized the previous few quarters. Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2010 reduce the valuations to 15.3 and 25.2 respectively – still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)
Another way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows the “normalized” price-earnings ratio of the S&P 500 Index is currently 21.2. This compares with a long-term average of 16.4 and implies an overvaluation of 29.3%. The graph below show data since 1950, but the actual calculations date back to 1871.
Albert Andrews, strategist of Société Générale, provides an interesting graph showing the run-up in the US forward PE has not been accompanied by higher expectations of long-term earnings growth. “This means the equity market is far more reliant on the expectations for strong 2010 growth being fulfilled, said Andrews.
Source: Société Générale – Global Strategy Weekly, January 11, 2010.
I repeat my conclusion of Sunday’s “Words” from the Wise” review: “It goes without saying that the strong rally since March is bound to be followed by a correction at some stage. But rather than pre-empting (and more often than not getting it wrong as a result of short-term noise), I will be guided by the longer-term charts and the yield curve to identify a major top. Meanwhile, I am watching valuations carefully, and specifically how the Q4 earnings reports stack up. Although I am treading with caution after the 75% rally in the mature markets and 109% in emerging markets, I am not ignoring good old stock picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty.”
