Profits, Earnings, PEs and Outlooks: Why You Should Reall....lly Care
Fascinatingly the markets are up today, led by Financials of all things. Will wonders and delusions never cease ? This despite the fact that, other than WMT earnings, all the economic news was unremittingly bad: foreclosures are up 55%, new house prices dropped -7.3%, continuing jobless claims accelerated and new claims were unexpectedly high and consumer inflation jumped 0.8% MtM, a 17-year high ! None of that sounds like the outlook is sanguine in the sense of good. Anyway, as threatened, we're going to revisit the outlook and consequences for corporate earnings and what it means for the market. Tracking which posts get the most attention, equally strangely if not more so, the diagnosis of a schizoid market attracted more attention then the careful dissection of the profits outlook (Talkin Profits: Economic Outlook, Earnings, Business Performance ?) and what the rapidly deteriorating economic outlook means. To put a point on it if we are indeed crossing a tipping point and starting into a consumer-driven downturn, as is now being widely recognized, ignoring profits and the current market valuations is dangerous to your financial health. On the grounds that perhaps we haven't made it entirely clear why you really care we're going to build a longish post walking thru various aspects of profits, earnings, PE's and the outlook. Just as one example most of the downturn so far in the S&P is due to Financials. If the economy turns over, as we expect, none of that is priced in.
Economy vs Markets
Just to set the stage let's start by considering the long-run relationship between the economy and the Markets. The meme is that markets are forward-looking though the WSJ noted that hasn't been true recently - as in the last decade ! Actually it's never been true. This multi-part chart shows the YoY% changes in GDP and the SP500 on top and the % growth in both since 1951. To our eyes the markets are still far ahead of where the state of the economy would justify their current levels.
Earnings Outlooks
Hopefully the prior post put enough evidence on the table about the structural relationships between the economy and profits that we can take it as given. And the translation between Profits and Earnings will also be taken as understood. That being the case the fundamental valuation equation we like is Graham-Dodd's: PE = (8.5 + 2*Growth)* 4.4/AAA-Yield. We'll dig into that a little later but taking it as a starting point the question becomes what are earnings expectations. And, much more importantly, do they make sense in view of our economic outlook. Take a look at the following chart which reproduces S&P's bottoms-up collection of analysts earnings prognostications and take a careful look at a) the revisions by sector and b) whether or not you believe the outlooks. And to put another point on it the two sectors that are up today and driving the market are Financials and Consumer Discretionary - with the big debate about a bottom in Financials raging onward (Riding the Storm - NOT: Breakdowns, Culture & Malfeasance in Finance).
Now if you're readers of this blog and these two sets of earnings estimates hang together for you you can probably stop reading. But if thinking that the Financials (in read) and the Discretionary and Technology outlooks (in yellow) have some questions that should be asked below we walk thru some valuable issues of PE and valuation that should be reflected. And aren't IOHO.
PE Valuation vs Long-term Investment Performance
Let's start by looking at the longer-term investment return verses PE Ratios with the accompanying chart (courtesy of John Mauldin). Here you can see total return vs initial PE Ratios. Currently the PE on the SP500 is running about 16, which according to this chart is pretty ambitious. Even if you think earnings will hold up what's your return likely to be ? According to this any reasonable increase in earnings is more than fully priced into the markets at this point. In fact according to this, in the best possible case, a 3-6% return over the next twenty years is the best outcome. Buying corporate bonds would be better, aside from some of their risks of course. :)
Return vs PE: the Margins of Safety
Ben Graham talks about a concept called "Margin of Safety", which can be translated as buy low and sell high. Or better, don't buy until you know that you're paying a fair value and KNOW when and how you'll get a reasonable return with a very high probability. Again via Mauldin but actually from Prieur du Pleiss of Plexus Asset Management we have this interesting little chart that looks at forward returns over certain time horizons vs PE Ratios. When you make value-investing, as opposed to speculative, decisions that margin of safety depends on getting into investments far below the current PE prices. In fact there's a real distribution of returns. And unless you think we're looking at the beginnings of another long-term bull market this ain't it.
PE Reversion to Mean and Value
Over time PE ratios tend to average out but the cycles around that mean can be very long indeed. As you may know by now real returns for the SP500 over the last ten years are negative, yet PEs are still above the long-term. And judging from this chart still have quite a ways to go. And there's the other little tidbit that the tend to settle below the long-run mean as well over 10-year and 1-year periods.
Not to mention the fact that we're still coming off the biggest investment driven boom in stock valuations in the post WW2 era. We would appear to be a long way from a fair, safety margined, PE in general. And that's before asking about the likely drop in earnings with a downturn in the economy.
Earnings, Outlooks, PE's and Reasonableness
Now let's take a look at one ginormous chart without dissecting every component. What it does is reproduce and compare actual and estimated earnings by major S&P sector over four different time periods. It's built from the quarterly S&P tables which are based on bottom-up analyst estimates. We've highlighted some of the total market (SP500) numbers in red just to make our points but you want to look at each sector. And ask yourself - are the estimates reasonable ? Bearing in mind what you've read here about the economic outlook in general and the specific comments we've made on various major GDP components ? And also bearing in mind that the analysts don't tend to make top-down assessments. Rather they talk to the executives at individual companies - always with the assumption that "my company is different and the exception". Maybe - but the collective result flies in the face of common sense, analysis and the recent headlines. A final observation - take a careful look at how earnings are being revised by sector. Pick one, say technology, and work thru whether the earnings, growth rates and PEs make any senses whatsoever. We'd argue that by and large they're still incredibly optimistic - which tends to be confirmed by the slow downward revision you can see in the numbers as reality overcomes optimism.
Graham-Dodd Re-visited
And one final chart that translates the G-D Valuation formula we promised to return to into a couple of tables and a chart so you can answer that last set of questions by quick inspection.
