A wonderful and brief blog post from Liam Denning at The Wall Street Journal’s Heard on the Street makes some interesting points about the current stock market that we believe readers of our blog would enjoy. As a value-oriented research shop, we always have an eye towards the overall market’s valuation. Denning does a good job of illustrating what the market has already priced-in for the future via the discounting mechanisms that are equity securities.
“…Stocks are ultimately discounting mechanisms. Judging what expectations are at any given moment is, granted, something of an art form. But some indicators are warning that, at 1,065 points, the market has overreached.
The first, and simplest, is the price-to-earnings multiple. These come in various forms, but many look expensive. Against trailing 12-month operating earnings — which exclude one-off charges — stocks are trading at a multiple of 27. The multiple of reported earnings is 142.
Looking ahead, consensus estimates for operating earnings result in a multiple of 19.5 for 2009 and 15.1 for 2010, when analysts expect S&P 500 companies to produce earnings of $70 a share.
Meanwhile, David Rosenberg, economist at Gluskin Sheff, reckons the S&P 500 is actually discounting earnings per share of $83 in 2010 using inflation adjusted Baa-rated bond yields as a proxy for the cost of equity.” –Heard on the Street 9/22/2009
If you are like me, when you see these numbers it makes your stomach turn. Valuation multiples have expanded tremendously in a very short period of time. Trailing twelve month earnings for the S&P 500 (excluding charges) currently stands at about $39.44. This is certainly a tremendous fall from the earnings peak of the summer of 2007, but it is still far better than the reported number which includes those massive write-downs. So, depending on whose 2010 earnings estimate you look at, either consensus analysts’ estimates or Rosenberg’s, they are predicting earnings growth of 77% or 110% roughly 15 months from now. It is that sort of rapid recovery that is being priced into the market during this rally.
There is no doubt that equities were selling at very distressed prices six months ago, and we would be the first to tell you that fear, uncertainty and doubts drove the market down to extremes. However, the market has turned a corner and is sending stocks higher based on positive sentiment, improving but not yet strong fundamentals and animal spirits. The riskiest stocks are enjoying the best ride, and on some days up to 20% of the market’s volume is from AIG (NYSE:AIG), Citigroup (NYSE:C), Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Traders risk appetite is back with a vengeance.
We see the need for caution all around the equity markets right now, as Ben Graham so astutely postulated, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” At Ockham, we are not market timers and we are not advising selling out of all equities to waiting for some impending doom, but we think that this is an opportunity to lighten up and take some risk out of your portfolio. Obviously, we fear that the persistent headwinds of joblessness, the develeraging cycle, and foreclosures may make the market look a little light on fundamentals when it comes time for the weigh-in.