If you watch and listen to business news, you must be getting very confused about whether the stock market is undervalued or overvalued. The bulls who appear on the financial shows assert that the stock market is inexpensive: "This market is as cheap as it has been for the past 2 decades-- or the past 18 years." They also may state that the price-earnings ratio, at 13 to 16 times estimated earnings depending upon how far out you go (2008 or 2009) is cheap. Their statements are correct.
At other times during the same day you may hear a bearish market maven try to convince the interviewer that the market is substantially overvalued and has a long way to go on the downside before it gets to fair valuation. The bearish interviewee will either discuss why the P/E ratio at 21 times 2008 earnings estimates or 24 times the latest 12 months earnings are closer to valuations found near market tops rather than market bottoms, and that the market is therefore highly vulnerable. These analysts are also correct.
The interviewer seldom if ever questions the disparities in the various market analysts' approaches to valuation. But, we will try to clear it up.
Few organizations are equipped to estimate the earnings of every company in the Standard and Poor's 500. It would require having analysts in every sector to study each individual stock and come up with the best guess possible. Virtually no institution or money management firm does this themselves. We generally rely on organizations such as Standard & Poor's to do the work for us.
Standard & Poor's has done more than enough work. Visit their website and you will find a myriad of different earnings estimates from which you can choose. S&P shows Reported Earnings, Operating Earnings, Core Earnings, Earnings with Pension Interest Adjustment, and other formats.
There are two main earnings numbers that Wall Street uses when discussing valuations. They either take the "reported earnings" or "operating earnings". Typically, the bulls use "operating earnings" and the bears use "reported earnings" because operating earnings are higher and reported earnings are lower. Also, it makes sense for the bears to use the last 12 months of earnings because they are usually lower and the bulls use forward operating earnings to help make their case. Of course, using the last 12 months is much more consistent since they are not dependent on estimates.
Operating earnings exclude write-offs while reported earnings include write-offs. That is the only difference and it's a difference that is getting much more important. As recently as the early 1990s operating and reported earnings were virtually the same. But then we entered the greatest financial mania of all time and the earnings numbers diverged.
There were so many write-offs by companies making unwise investments and then undoing them that operating earnings grew much faster than reported earnings. The write offs that had been sporadic and unusual became common practice for many companies. Using operating earnings is now like playing in a major golf tournament that doesn't count any penalty strokes for hitting the ball in a water hazard or out of bounds.
Let's take a look at the numbers. Operating earnings for the S&P 500 for 2007 were $82.54 while reported earnings were just over $66. The estimated numbers for 2008 are just under $90 for the operating earnings and just under $69 for reported earnings. By the way, these reported numbers have just recently been revised downward drastically due to the slowdown in the US economy. Now you can see why there is such a discrepancy in the market mavens' point of view. If you are a bull you will say the market is trading at a very reasonable 16 multiple on the $89.44 of earnings in 2008 and 13 times the 2009 estimate of $110.44. On the other hand if you are a bear, or just a reasonable person, you can see the market is trading at 24 times trailing earnings ($60.41) and about 21 times estimated 2008 "reported earnings" ($68.96).
Unless you believe that we will be trading at a "permanent plateau" as did the noted economist Irving Fisher in 1929, you might want to consider the more distant peak and trough multiples. Over the last 75 years most market peaks topped at around 20 times reported earnings (until the financial mania) and the troughs occurred at around 10 times earnings. During the financial mania of the late 1990s P/Es skyrocketed to over 40 times earnings.
We can do more with earnings. The best way to measure present earnings and future earnings is to smooth them out over long periods of time. Earnings can only grow at approximately 6% a year over the long term. The trend is limited by the growth in real GDP plus inflation-in other words, nominal GDP. Long term, real GDP cannot grow faster than the increase in the labor force plus the increase in productivity. Even if you don't accept this in theory, look at a long-term chart of earnings and draw a 6% growth line thru the earnings points. You will see how well it fits. It is clear that earnings sometimes rise above the line and sometimes fall below the line, but earnings also revert to the mean of the 6% line.
Going back to 1950, every instance where actual earnings rose above trend-line earnings was followed by a period where actual earnings went well below trend-line earnings. We believe we have entered such a period now, and the market is trading at such a high multiple of these earnings, it will be difficult to make money from this level and you could lose a lot of money.
