Sunday, April 01, 2007

Fair Value - 40% Off (Not a Forecast, but Don't Rule it Out) / hussman

once again nice "anti spin" from hussman.

einmal mehr keine wall street gefärbte sicht von hussman.

With the prospect for a near term Fed cut now properly removed, Wall Street's remaining speculative hopes must now be shifted to earnings. For now, investors still seem willing to tolerate “price to forward operating earnings” multiples that are extremely elevated, because they don't even realize that these multiples are extremely elevated. Nor do they seem to realize that operating earnings have no definition under generally accepted accounting principles. Nor do they seem to realize how strong an assumption it is to believe that profit margins will remain at unusual historic highs in the face of rising unit labor costs

.... I believe that it is important for investors to understand how profoundly incorrect and potentially dangerous it is to accept the incessant argument that stocks are cheap on a "forward operating earnings basis

It is the trailing P/E on reported net earnings that has a historical average of about 15, not the forward P/E on estimated operating earnings (which Asness estimates as having a historical norm closer to 11).

thanks to

Even that average for the trailing P/E is itself biased upward because earnings typically collapse during recessions, driving P/E ratios to extreme levels during those periods. Those get added into the average, and results in a “historical norm” of 15. If you correct for those spikes, the historical average P/E for the S&P 500 is even lower.

the current price/peak earnings ratio is about 17.5, well above the historical average of 14 for the price/peak earnings ratio.

But we're just getting warmed up. If we look closely at S&P 500 earnings, we find that we can draw a 6% growth trendline connecting earnings peaks from economic cycle to economic cycle as far back as we care to look. So even though earnings sometimes grow rapidly from the trough of a recession to the peak of an economic expansion, at rates sometimes exceeding 20% annually, we also find that the peak-to-peak growth rate has been very well contained historically at just 6%.

given the unusual spike in profit margins, they have actually moved slightly (but not significantly) above that line. On that basis, the current price/earnings ratio, normalized for the position of earnings at present, is about 75% above its historical norm (alternatively, the historical norm would be about 40% below current levels).

Given the current multiple of 17.5 times those trendline earnings, I am certainly not suggesting any probability of the market moving to such levels. But to rule out a decline of 30-40% on the S&P 500 would be to rule out a move to valuations that have historically been standard, normal, commonplace.

that green line is a fairly robust estimate of where the S&P 500 would have to trade in order for stocks to be priced to deliver long-term returns of 10% annually. When the actual S&P 500 (blue line) is above that green line, we don't have to conclude that the market is “overvalued” – just that it's a good likelihood that stocks are priced to deliver long-term returns of far less than 10% annually from those levels.

Where is that green line today? 850 – about 40% below current levels.

Again, that doesn't imply that stocks have to actually suffer a decline of that magnitude. Nor do we need such a decline in order to justify an unhedged investment stance. It's just that investors should not expect the S&P 500 to reliably deliver long-term returns of 10% annually or better until it does. You'll note that there are also points in history when the S&P 500 traded substantially below that 10% valuation line. Those were points where stocks were priced to deliver long-term returns reliably above 10% annually, and in fact, they did exactly that.

Presently, we're not anywhere close to such a situation. Food for thought

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