One of the bulls’ major reasons for being optimistic on
the stock market is their view that stocks are reasonably valued at 14-to-15
times earnings, well within past norms.
They consistently state this view on financial TV and in print without
ever being challenged by their interviewers.
The far smaller----and shrinking---- number of bears, on the other hand,
contends that the market is substantially overvalued. We believe that the bulls are using a flawed
model that would not have had predictive value in the past, and that the bears
will prove to be correct, as they were in 2000 and 2007.
How can two differing groups look at the same set of
facts and come to such diametrically opposed conclusions? Simply put, the bulls use the current price
of the S&P 500 and divide it by estimated forward-looking operating
earnings to arrive at the current price-to-earnings ratio (P/E). Therefore, based on today’s S&P closing
price of 1854 and consensus estimated 2014 operating earnings of $122, they come
up with a reasonable P/E of 15, or even as low as 13 times if they use the 2015
estimate of $138.
The key words to focus on in the preceding paragraph are “estimated”,
“forward-looking”, and “operating”. The
bears make a similar calculation, but use “actual”, “trailing” and “reported”
earnings----and for good reason. The
problems are as follows. First,
operating earnings usually differ considerably from earnings calculated in
accordance with “generally accepted accounting principles” (GAAP). Operating earnings start with reported
earnings, and then add back a number of expenses considered non-recurring, such
as severance pay, start-ups, inventory write-downs, opening or closing of
facilities and any other number of expenses that corporate managers may choose
at their discretion.[More]