Wednesday, February 04, 2009

Exaggerated Earnings and P/E Pipe Dreams

I am not a fundamental investor, which means I do not make investment decisions based on corporate earnings forecasts. Stock prices go up or down based on whether investors are primarily buying or selling stocks. Period. Sometimes a company loses money but the stock price goes up because people buy it anyways, and sometimes a highly profitable company sees its stock price plunge because of irrational panic. Predicting the stock market is more about understanding human behavior than reading balance sheets.

That being said, corporate earnings are not entirely irrelevant. As I noted in my previous post, the real "as reported" price-to-earnings ratio (P/E) of the S&P 500 typically varies between 10 and 20, meaning the grand average price of all S&P 500 companies is usually between 10 and 20 times their annual earnings, or about 15 times earnings on average. Therefore the S&P 500 is considered overpriced when the P/E is more than 15, and under-priced when it's below 15. One could imagine a simple market-timing strategy based on the P/E ratio which invests 100% in stocks at a P/E of 10, but cashes out completely if the P/E reaches 20.

Unfortunately, the majority of websites, newsletters, and media outlets don't use the real P/E ratio of the S&P 500. Instead, they usually provide the P/E ratio based on "operating earnings." Bob Brinker, for instance, uses operating earnings for his forecasts, and it's one of the reasons his portfolios have been decimated by this bear market.

Operating earnings are optimistic, idealized calculations that ignore one-time losses that companies don't consider to be part of their normal operating budgets. Right now, for instance, banks which have lost billions of dollars in defaulted loan payments are not necessarily subtracting them from their operating budget. Future projections of these earnings assume that their budgets will go right back to what they were before the losses, which is a highly dubious assumption. Real "as-reported" earnings, on the other hand, don't hide anything, and include every blemish in the budget.

The following table, using data from the Standard and Poor's website, demonstrates just how much of a difference there can be between the two earnings calculations:

Price-to-Earnings Ratio for S&P 500 Companies
QuarterReal P/E*Operating P/E*
2008 Q32518
2008 Q42414
2009 Q1**2815
2009 Q2**3217
2009 Q3**3017
*Earnings (E) are the total earnings of the previous 12 months (4 quarters).
**The 2009 forecasts predict what the P/E ratio would be if the S&P 500 index remained at its current level of 840. If the S&P 500 index falls, that would be a reduction in "P," and thus it would lower the P/E ratio.

It is curious that operating earnings remain 40% to 90% higher (P/E ratios lower) than real earnings for five straight quarters even though one-time losses supposedly constitute the only difference. To my eye, large differences between the two columns seem to be happening on a regular and consistent basis. Does anyone else smell something fishy? To make matters worse, earnings forecasts have been steadily decreasing for the past few months, which has raised P/E ratio forecasts to ever more over-valued levels. These forecast revisions may continue for a while still.

If you're not already baffled that anyone uses operating earnings, then take a look at what can be found on Yahoo Finance. There are two ETFs that mimic the S&P 500 index, SPY and IVV, and Yahoo reports today that their P/E ratios are between 10 and 11, which is even more optimistic than the best P/E ratio in the above table. I submit that the P/E numbers reported by Yahoo are pure fantasy, because there are no earnings numbers - past or future - high enough to give such low P/Es.

So the P/E ratio of the U.S. stock market is somewhere between 10 and 28 depending on whom you ask, and these numbers are being revised every week. What's an investor to do? Well, I mostly ignore earnings, because even the real earnings numbers can hide certain details.

The only fundamental number that affects my investment decisions is the dividend yield, because it can't be exaggerated. The dividend yield is the sum of all cash payments made to stockholders in the past 12 months divided by the stock price. That's it! There's nothing to fudge, hide, or imagine. Check various websites for the dividend yield of the S&P 500 index, (yahoo, google, Standard and Poor's, Wall Street Journal) and suddenly you find agreement where before there were different universes of earnings. The dividend yield of the S&P 500 has historically oscillated between 3% (overvalued) and 6% (undervalued), meaning a simple form of market-timing could be based on this one number.

Currently the yield of the S&P 500 index is an over-valued 3.4%. Assuming that the dividend dollar amounts remain the same into the future, the S&P would have to fall to 630 to reach a fairly-valued yield of 4.5%. In order to return to a yield of 6%, the S&P would have to fall to about 475. I doubt that U.S. corporations will be able to maintain last year's dividend payments this year, so there is a fundamental basis for expecting even greater declines.

Remember to take all of this with a grain of salt, however. If investors have the desire to buy stocks and the money to do it, then prices will rise regardless of the fundamentals, just like they did in 1998-2000. It just so happens that fundamental and technical analysis forecasts are in agreement that prices will keep falling for a while.


Tim said...

I thought I read that the stock just had to trade in the US to be on the SP 500. I was wrong. That's what you get for depending on Wikipedia. Good post. You should write for a magazine

Jody said...

"You should write for a magazine."

Thanks Tim! That's actually not a bad idea. If you have any suggestions on where to start looking for a taker, I'm all ears (or eyes).

wooderson316 said...

Great post Jody. Well done.

Anonymous said...

Thanks for expanding on the topic of operating earning vs. reported earning.


jeff said...

What do you suppose accounts for the continued relative optimism in market sentiment (that you have partially based your GRZZX strategy on) in light of plummeting markets and unending bad news in the financial world?

Rob said...

As I started reading the part about using dividend yield as another guide, I started thinking to myself that a good number of 500 companies already have or will be reducing the dividend payout. So, the yield will go lower yet. Then, you mentioned the same thing. This is all great stuff. I'm an options player of SPY and puts have been doing very well for me since the pre-Christmas false rally.

Jody said...


I can only speculate. I've seen several pundits declare that we've reached the bottom of the bear market, which is certainly an optimistic sentiment for long-term investors.

There may also be a crowd of traders who are anticipating a quick rally next week after the stimulus bill is passed by Congress. This group would be sitting in stocks and options right now with their finger poised over the "sell" button.

Jody said...

Thanks, Rob.

I think you're wise to be using puts when the majority are using calls right now. It's another example of winning by being a contrarian.

Anonymous said...

What signals (indicators) do you use to exit your current GRZZX position?

Will you exit your position incrementally or all at once?


Jody said...

There are many possibilities. The best case scenario would be a market plunge accompanied by increased pessimism. In that case I would probably cash out over a few days as technical indicators trip and sentiment passes a pessimistic threshold.

In the worst case, the market could bounce around at these levels for a while longer and then produce a bull market signal. If that were to happen then I would have to cash out of GRZZX without making any gains, do an about-face, and invest in a bull fund.

Anonymous said...

I was impressed by the market turn around to the positive direction today (Thursday) in light of bad news:

A. Initial claims: -626K vs -580K;
B. Big miss in CSCO's guidance;

Are these market actions relevant to your technical analysis?


Jody said...

Daily changes in the S&P 500 are relevant to my method. Jobless claims and earnings misses are not.

Anonymous said...

I lean entirely toward fundamental analysis, and focus more in the economic big picture. This big picture I am seeing is:

We are in a deep recession brought on by debt and consumption excess (we’re going through a period where a 50-year credit expansion has moved to contraction). The cleansing process will be long and painful, but absolutely necessary ( we are going to have a number of years where aggregate demand is low).

Thus, it may take a long time (could be years) before the economy recovers. However, what is not obvious to me is that how many years of economic misery has the stock market discounted. Nevertheless, the easiest mistake to be made is calling the bottom too early.

Your technical analysis (if it works) will be my missing pieces of puzzle.


Jody said...

Let's hope I get it right then!

Anonymous said...

Surprise, Surprise.. Dow is up about 200 points even with horrid unemployment numbers... all because of excitement over the stimulus plan. Any bets on when the market will advance downward to correct this nonsense?

Jody said...

Right now I have no way of knowing *when* the market is going to make a move. My GRZZX position could pay off Monday, or it could take six months.

Anonymous said...

Do you consider this week's market price action being bullish?

From a technical analysis point of view, how do you justify maintaining your GRZZX position going forward?


Jody said...

Single large up days like today don't usually support sustained rallies. I justify my GRZZX position because the market will eventually be lower than it is today, meaning GRZZX will be higher.

I am not a day trader. I have no advice to give to day traders except "good luck."