"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted. I expect to see the stock market a good deal higher within a few months." - Dr. Irving Fisher, Professor of Economics at Yale University, one of the most important US economists of his day, speaking on October 17, 1929, a few weeks before the Great Crash.
"What," more than a few readers ask, "do you think of the new highs on the Dow? Don't you have to admit we are not in a secular bear market? Can't you just enjoy the new bull?" If it were a matter of just admitting I'm wrong, that would be the easy part. I have been wrong lots of times and will be wrong again. But the data keeps telling me that there is more to the story. This week we look at earnings and investor expectations. In the man bites dog category, we visit with a very mainstream analyst who says earnings will fall next year. But companies are going to trumpet much higher earnings. There is a coming dissonance that suggests a problem in future valuations.
Cycles Are About Valuation and Not Price
First, let's define what I mean by secular bull and bear markets. I think that looking at secular market cycles in terms of price is not the most useful. In Bull's-Eye Investing, I spent the first part of the book making the case that one should look at cycles in terms of valuation. To understand this, let's look at some of the charts from the book from Crestmont Research (run by my good friend Ed Easterling.)
What we find is that markets go from high valuations to low valuations back to high valuations. Looking over the cycles of the last century, we find that this process is repeated time and again. The full cycle can last as long as 40 years or as short as 8.
You can have powerful bull and bear markets (in terms of price) within these long term secular valuation cycles. But you always go from high to low to high valuations. There has never been a time when valuations go to some mid-point and then turn around to make new highs or lows. You can see the actual cycles at http://www.crestmontresearch.com/pdfs/Stock%20Secular%20Chart.pdf.
You can get a graphic picture of what the cycles look like by going to http://www.2000wave.com/graphs.asp. What you will find is a chart that shows you what your annualized returns would have been starting from any year in the last century and going forward 5, 10 or 50 years, year by year.
For instance, starting in 1929 and going forward for 50 years, you would have averaged 2% after inflation and taxes. Not what you need for a happy retirement. But if you start in 1950 and go forward for 50 years, you get 7% after inflation and taxes. Now that is a good return. What is the difference?
Valuations. What the chart shows is that your long term returns heavily depend on the valuation of the market at the time you invest.
Unless things are different this time, we should expect to see lower P/E valuations (Price to Earnings) in the future. Now this can happen in one of two ways. Either earnings increase as the market stays flat, or the market drops, or a combination of both.
You can go to the S&P web site and look at the earnings for the S&P 500, both historic and projected. Going back ten years to the second quarter of 1996, we have seen reported earnings rise from $9.26 to $20.11, which is a little more than double. That is roughly 7% compound earnings. The S&P at that time was 670, a little less than half of where it is today. (http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS)
I fully expect earnings for the S&P 500 to double over the next 10-12 years. That is in the 6-7% compound return range and is in line with historic growth over the last century. (As an aside, part of the growth in earnings from the S&P 500 is because they replace lagging companies in the index with newer, faster growing firms. Over time, this is a significant factor in S&P earnings growth.) If the market was flat over that time (something I do not think will happen), P/E ratios would be in the single digits.
What are valuations at today? On the tables in the link above, the trailing 12 month core P/E as of June 30 was 18. The market is up 5% since that time, but earnings are rising as well, so the core P/E will probably in that range as well when all the numbers for the third quarter are in. 18 is at the upper end of the historic P/E range. 12 month forward P/E ratios are in the 16 range.
Historically, no long term bull market ever started with P/E ratios this high. So, why is the market rising? Because as we will see, investors now expect that growth we have seen in the last three years to continue for the next three years. We take the past and extrapolate those returns into the future. More on that later, but first let's return to the S&P earnings tables.
S&P makes estimates for future earnings. They track operating earnings, reported earnings and core earnings. Reported earnings are based on GAAP, or generally accepted accounting principles. Operating earnings are what companies and bulls like to use. Operating earnings are of what I like to call EBBS - Earnings Before Bad Stuff or Earnings Before BS. To get higher operating earnings, a company simply states that certain items are one time charges and shouldn't really count, therefore operating earnings are nearly always higher than reported earnings.
This used to be really bad in the late '90s and early part of this decade. My favorite item of what management can decide to call a one-time charge is when Waste Management decided that painting its garbage trucks was a one-time expense. It gave a whole new meaning to garbage accounting.
Recently, with the new rules, the divergence between reported and real earnings has been rather small. A few years ago, S&P started giving us what they call core earnings. This is earnings deducting for options and true pension costs. S&P should be applauded for introducing this. And as new accounting rules make businesses account for options and true pension costs, reported and core earnings are starting to get closer.
Analysts Project Earnings to Fall
You read that right. S&P is projecting reported earnings to fall in 2007. Let's look at the following numbers copied off the S&P earnings table. These are the actual operating and reported earnings for the last three quarters and the estimated earnings for the next six. Remember what I said about operating and reported earnings getting closer to each other? If S&P projections are right, that trend is about to end.
Today the difference is about 3%, which is not unreasonable. But starting next quarter and then accelerating in the second quarter of next year, the projected difference is quite large. They suggest that operating earnings will be 36% higher than reported earnings. Operating earnings are projected to rise by almost 14% from the end of 2006 to the end of 2007. 2007 doesn't sound like a bad year, does it?
But that's not the whole story. S&P think that reported earnings will be lower in the 3rd and 4th quarters of 2007 than they are in the same respective quarters of this year, by as much as 6%! That's a 20% difference. Let's look at the numbers and then do some analysis.
I talked to Howard Silverblatt of S&P, who was very helpful on a Friday evening. I asked why are reported earnings projected to go down? Basically, S&P analysts are expecting a lot of write-offs and other expenses to crop up later next year. These will be put forth as EBBS, so therefore CEOs are going to suggest that you should ignore those pesky write-offs.
Thus the divergence between operating and reported earnings. But there is more to the story. Howard did a study which shows that the further down the food chain (in terms of size) you go, the more glaring the divergence, both within the S&P 500 and in the entire universe of stocks. It seems there is more pressure on smaller companies to make their numbers look better than there is on the larger company. It speaks to the whole corporate governance issue.
As an aside, Howard noted that 42 S&P 500 companies have been served notice by either the SEC or the Department of Justice. That is a lot of management time focused on non-productive matters.
So, even without a recession or an economic slowdown, earnings are likely to disappoint next year. And when the expectations of investors are disappointed, it creates problem for stock valuations. Let's revisit a study I cited about three years ago which speaks to that very point.
The Evidence for Investor Overreaction
The problem with earning disappointments is forcefully born out by a study produced in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin. The work, entitled "Investor Overreaction: Evidence That Its Basis is Psychological" is a well written analysis of investor behavior which illustrates that perceptions are more important than the fundamentals. Let's look at that study in detail. Stay with me. This is important.
In any given year, there are stocks which are in favor, as evidenced by high valuations and rising prices. There are also stocks which are just the opposite. Dreman and Lufkin (or DL for the rest of this letter) look at a database for 4,721 companies from 1973 through 1998. Each year, they divide the database up into five parts, or quintiles, based upon their perceived market valuations. They separately study Price to Book Value (P/BV), Price to Cash Flow (P/CF) and the traditional Price to Earnings (P/E). This creates three separate ways to analyze stocks by value for any given year, so as to remove the bias that might occur from just using one measure of valuation.
The top and bottom quintile become stock investment "portfolios" for all three valuation measures. You might think of them as a mutual fund created to buy just these stocks. They then look ten years back and five years forward for these portfolios. There is enough data to create 85 such portfolios or funds. They first analyze these portfolios as how they do relative to the market or the average of all the stocks. They then analyze these portfolios in terms of five basic investment fundamentals: Cash Flow Growth, Sales Growth, Earnings Growth, Return on Equity and Profit Margin. They do this latter test to see if you can discern a fundamental reason for the price action of the stock.
I wish Dreman would make these tables available for free - hint, hint - on his website. It would be a good reason to visit. But let me describe what I think are the more pertinent facts which leap out as we go through their presentation.
First, both the "out-performance" and "under-performance" of these stocks happens in the ten years leading up to the formation of the portfolio. Almost immediately upon creating the portfolio, the price performance comparisons change, and change dramatically. The "in-favor" stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.
I should point out that other studies, which Dreman does not cite, seem to indicate that the actual experience of many investors is more like these static portfolios than one might first think. That is because investors tend to chase price performance. In fact, the higher the price and more rapid the movement, the more new investors there are who jump in. The Dalbar study, among many others, shows us that investors do not actually make what the mutual funds make because they chase the hottest funds, buying high and selling low when the funds do not live up to their expectations. The key word, as we will see later, is expectations. Other studies document that investors tend to chase the latest hot stock and shun those which are lagging in price performance. Thus, forming a portfolio of the highest performing quintiles is an uncanny mirror to what happens in the real world.
Why does this "chasing the hot stock" happen? DL tells us it is because investors become over-confident that the trends of the fundamentals in the first ten years will repeat forever, "...thereby carrying the prices of stocks that appear to have the 'best' and 'worst' prospects. Investors are likely to forecast a future not very different from the recent past, i.e., continuing improving fundamentals for favorites and deteriorating fundamentals for out-of-favor issues. Such forecasts result in favorites being overpriced, while out-of-favor issues are priced at a substantial discount to the real worth. The extrapolation of past results well into the future and the high confidence in the precise forecast is one of the most common errors made in finance."
In other letters, I have highlighted the research that shows the more we learn about a stock, the more we think we are competent to analyze it and the more convinced we are of the correctness of our judgment.
Since you are not looking at the graphs, let me describe them for you. Predictably, the fundamentals improve quite steadily for the first ten years for the favorite stocks in comparison to the entire universe of stocks. But the price performance rises at very high rates, far faster than the fundamentals, particularly in the latter years. It clearly accelerates. It seems the longer a stock does well the more confident investors are that it will continue to do well and thereby award it with higher and higher multiples. The exact opposite is true of the out-of-favor stocks. Even though many of the fundamentals were actually slowly improving, in relationship to the market as a whole, they were lagging and the market punished them with ever lower relative prices.
At five years prior to the formation of a portfolio, the trends of each group were set in place. The next five years just reinforced these trends. This reinforces the perceptions about these stocks and increases the level of confidence about the future. Again, past (and accumulated and reinforced over time) perception creates future price action.
Never mind that it is impossible for Dell to grow 50% a year or GE to compound earnings at 15% forever. As many times as we say it, investors continue to ignore the old saw "Past performance is not indicative of future results."
How much better did the good performing stocks do than the bad performing stocks in the ten years prior to creating the portfolios? The highest P/BV (Price to Book Value) stocks outperformed the market by 187%. The lowest stocks underperformed the market by -79% for a differential of 266%! If you look at the P/CF (Price to Cash Flow) the differential between the two is 172%.
Yet in the next five years, the hot stocks underperformed the market by a negative -26% on a P/BV basis, and -30% on a P/CF basis. The out of favor stocks did 33% and 22% better than the market, respectively. This is a HUGE reversal of trend.
So, what happened? Did the trends stop? Did the former outcasts finally get their act together and start to show better fundamentals than the all-stars? The answer is a very curious "no."
"...there is no reversal in fundamentals to match the reversal in returns. That is, as favored stocks go from outperforming the market, their fundamentals do not deteriorate significantly, in some case they actually improve.... The fundamentals of the 'worst' stocks are weaker than both those of the market and of the 'best' stocks in both periods."
In some cases, the trends of the worst stocks actually got worse. Even as the out-of-favor stocks improved in relative performance in the last five years, their cash flow growth actually fell from 14.6% to 6.6%. While cash flow growth for the best performing stocks did drop by 6%, it was still almost 2.5 times that of the lower group. Read the following carefully:
"Thus, while there is a marked transition in the return profiles [share price], with value stocks underperforming growth in the prior period and outperforming growth stocks in the measurement period, this is not true for fundamentals. In nearly every panel [areas in which they made measurements], fundamentals for growth stocks are better than those for value stocks both before and after portfolio formation ."
"Although there is a major reversal in the returns [prices] to the best and worst stocks, there is no corresponding reversal in the fundamentals." In fact, in many cases the fundamentals continue to improve for the growth stocks and deteriorate for the value stocks. The data and the graphs clearly show the fundamentals for the growth stocks clearly beat those of the value stocks even for the five years after portfolio formation. And yet, there is a very stark reversal in price. Why, if not based upon the fundamentals?
DL goes to another research paper which shows (Dreman and Berry - DB) "...that even a small earnings surprise can initiate a reversal in returns that lasts many years. They demonstrate that negative surprises on favorite stocks result in significant underperformance of this group not only in the year of the surprise but for at least four years following the initial event. They also show that positive surprises on out-of-favor stocks resulted in significant outperformance in the year of the surprise, and again for at least the four years following the initial event. DB attributes these results to major changes in investor expectations following the surprise."
So where was the overreaction? Was it in the years leading up to the surprise which resulted in a very high or low priced stock (relative to the fundamentals), or was it in the immediate reaction to the surprise?
Other studies show analysts (as opposed to investors) are too slow to react to earnings surprises by being too slow to adjust earnings. Even nine months later, analysts expectations are too high.
That Permanently High Plateau
Investor expectations are clearly high. Money is pouring into US mutual funds. Last month saw $2.2 billion, the second highest month of inflows this year. And so far this month, we have seen $2.6 billion, says Trimtabs. Since gold disappointed, investors started to bail last month. They took out $214 million last month in mutual funds that invest in gold and precious metals, as opposed to the previous six months which saw an average of $129 million in additions. Of course, gold is back above $600 as the hot money runs for the exits.
Investors are acting like stocks are at a permanently high plateau. They are projecting 15% increases in earnings out a very long time. Never mind that this is double the historical rate of growth, and far faster than the economy is growing. Yes, some of that "excess" growth can be explained by share buybacks and some of it can be explained by profits from international operations in countries where growth is higher. But it is unrealistic to expect earnings to grow at the rate they have been. Stocks are getting priced to perfection once again.
The Wall Street Journal today has a headline that says: "Short Interest Inches to Record On the Big Board." That means, the bulls will tell us, that an explosive short covering rally is just around the corner. Possibly.
But let me give you two quotes from an earlier edition of the Wall Street Journal, sent to me be good friend Chris Cooper which he found in an old Joe Granville letter:
"Because of the big short interest, it is the growing view that a good technical recovery is in prospect...and that the internal market structure is probably stronger than in some time." 16-Sep-1929
"Of course, the operations for a rally were aided by the technical position of the market which had become oversold in many directions by the bears, with the short interest larger than in some time." 9-Oct-1929
Much of the recent rise in the Dow 30 has been from less than ten of the components. Caterpillar has counted for 500 points by itself since the low. Richard Russell notes that the Dow Transports are not confirming a new bull.
Where are the new highs on the other indexes? Given the inverted yield curve, the continued problems in the critical housing markets and the rest of the forward looking themes I have discussed over the past few months, I still believe we are going to get to buy this market at much lower prices and better valuations.
By the way, among other things, I suggested buying bonds six years ago when I forecast a recession. You would have been far better off than with an index of the S&P 500. Maybe I will be wrong this time, but you still have to go with the data, until it becomes really clear that this time it is different.
We live in interesting times.
Birthdays and What are the Odds?
It is time to hit the send button. I have kids in from college this weekend and want to get home to see them. All the kids (7 of them) and significant others and friends will be gathering tomorrow night for a joint birthday party for me and #2 son. I have just had mine and his is in two weeks. It will make for a fun weekend, and then dinner with more friends Sunday night.
I have had several reasons lately to ponder my mortality. It is something I normally try to avoid. Riding in the car yesterday, I heard this report on CNN and was reminded yet again. We have all heard of the very sad death of Steve Irwin being stung through the heart by a stingray. But he was down in the water with the stingray.
82 year old James Bertakis, of Lighthouse Point, Fla., was boating on the inter-coastal water way with his granddaughter and a friend Wednesday when a spotted eagle stingray flopped onto the boat and stung Bertakis in the chest as he tried to brush it off, driving part of the barb into his heart. The women steered the boat to shore and called 911.
Bertakis has evidently survived surgery, thankfully. But what are the odds? Not of surviving, mind you, but of sitting in your boat and having a bottom dwelling stingray leap in and stab you in the heart?
A number of things of late have made me realize how all too ephemeral our hold on life is. It is the grace of God that we survive driving while talking on cell phones, let alone the outside the box risk of a stingray leaping into your boat.
It makes me appreciate the good times with my family and friends all the more. If you are looking for good value, more time with family and friends is certainly one place to find it.
Your always looking for good values analyst,
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