The recent bear market rally has been feeding on survey data that point to a stabilizing US economy. Investors and commentators alike are seeing green shoots all over the place with the S&P 500 up 32% since the March low of 677.
The run-up in stock prices is implicitly a run-up in earnings expectations, and thus we ask ourselves whether the earnings expectations are reasonable or out of sync with economic reality.
The reported current and forward PE-ratios of 14.1 and 15.1, respectively, suggest fairly cheap equities, but these metrics are usually distorted on (at least one of) two accounts:
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They do not include negative earnings in the denominator, thereby artificially lowering the metrics. While a negative PE-ratio is not meaningful, losses must still be realized when speaking about the PE-ratio on an index level. They do not simply disappear. If you invest in the S&P 500 you will incur losses from loss-generating companies and that should be reflected in the price-earnings ratio.
- They are so-called operating earnings, which is basically earnings minus all the bad stuff. The argument in favor of operating earnings usually goes along the lines that special items are not a reflection of the underlying business. However, when special items start to include all the write-offs of bad assets accumulated on balance sheets they are no longer non-operating earnings, but rather operating earnings in a badly managed company. Therefore the use of operating a PE-ratio might make sense for single stocks, but not when pricing an index.
A more reasonable trailing twelve months (TTM) PE-ratio incorporating both non-operating earnings and negative earnings in the denominator results in a much higher ratio of 126. The S&P 500, in other words, certainly does not look cheap to us. Considering that the average TTM PE-ratio in recessions since 1964 has been approximately 16, stocks could come down dramatically.
The use of trailing earnings can be criticized on grounds that equities are prices according to future earnings expectations, but our forward PE-ratio does not lend much support to green shoot followers either. With investors willing to pay 69.8 times forward GAAP earnings for the S&P 500 index, fundamental valuation appears to have gone out the window.
In conclusion:
- The reported S&P 500 PE-ratios are too low since companies with negative earnings are only included in the numerator. In addition only operating earnings are added.
- The vast difference between the forward operating PE-ratio of 15.1 and the forward GAAP PE-ratio of 69.8 implies that 78% of forecasted operating earnings will be cancelled out by one-off losses. Continuing one-offs, anyone?
- Even when accepting the reported operating PE-ratio, the trailing ratio of 15.1 is still higher than the historical recession average of 13.3, suggesting that stock prices could come down by 12%.
- Insiders are exiting shares at the fastest pace in two years. The insiders, in other words, are taking advantage of the stock market rally to dump their seriously overvalued shares.
The rally that started in March is based on selection bias in the extreme. When the correct price-earnings ratio is applied the future does not look quite as bright as the green shoot crowd would have us believe. Equities must come down as lower-than expected earnings are realized and expectations revised downwards.