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If You Don't Like the Numbers, Then Change Them


by John Mauldin
February 27, 2009

Let's be clear. I like Jeremy Siegel. He is a very nice and very smart gentleman. But in his op-ed piece, I think he was talking his book, if you can pardon the pun.

I have been writing for a long time about the rather dismal forecasting ability of the analysts who predict the earnings for the S&P 500. Each month it gets uglier. But just for fun, let's review a few charts. This first chart shows analysts' estimates for 2008. The last number is with 94% of the 500 companies reporting. Earnings forecast have been knocked down by over 70% since the end of 2007. That is a monumental miss.



Now let's look at forecasts for 2009.



Based on 2008 as-reported earnings, the S&P 500, which closed at 735 today, has a trailing P/E of 52. The forward P/E, based on 2009 projected earnings, is 22.7. But the trailing 12-month P/E for the end of the second quarter, based on the last half of 2008 and projections for 2009, is a nosebleed 51.2. (The combination of actual and projected earnings is $14.36 per share.) Mind you, that is after a rather healthy drop in the price of the index!

In his op-ed, Jeremy says that looking at the earnings for the entire index can be misleading. "What this dismal news actually reflects is the bizarre way in which the S&P (and most other index providers) calculate "aggregate" earnings and P/E ratios for their indexes. Unlike their calculations of returns, S&P adds together, dollar for dollar, the large losses of a few firms without any regard to the market weight of the firm in the S&P 500. If they instead weight each firm's earnings by its relative market weight, identical to how they calculate returns on the S&P 500, the earnings picture becomes far brighter."

He uses the illustration of Exxon and Jones Apparel Group, the largest and smallest, respectively, two stocks in the index. Exxon has a weighting 1,381 times that of JAG. If by some chance one made $10 billion and the other lost $10 billion, the effect on aggregate earnings would add up to zero. But if you counted earnings relative to size, you would get a much different picture.

There are 80 companies which had a combined (so far) loss of $240 billion in 2008, which takes about $27 per share of the total earnings, although these companies only account for 6.4% of the index. If you figured earnings by market capitalization, you would get earnings at $71.10, says Jeremy. At today's close, that makes the P/E closer to 10! And that does sound better than my analysis above. He concludes:

"No one can deny that the recent economic downturn has badly hurt corporate earnings. But let's not fool ourselves into thinking that this is an expensive market. When computed accurately, P/E ratios show that this market is much cheaper than is currently being reported by the S&P. Those who venture into today's stock market are indeed buying good values."

So which is it? A P/E of 10? Or 20? Or 50?!?!? Who is fooling whom?

First, let me state unequivocally that there are stocks in the S&P 500 that are good values. If you buy them today you will be rewarded in the medium and long run. Don't ask me which ones, because I don't do stocks -- I have enough on my plate looking at investment managers and the economy. But there are value managers who will do well from this point. The fact that they have been hammered by 50% or more in the past year is another story for another letter. (But nearly all of them made the case that "today" was a good time to buy their fund and did so every day for the last year.)

I think there are some problems with Jeremy's methodology. Do you weight CITI, for instance, at their market cap at the beginning of the quarter, or at the end? AIG? B of A? That could make a huge difference. And what about when the financials were contributing so much to earnings just a few years ago?

Financial stocks were 22% of the index at their highs, and an even greater share of the earnings. They are now down to 10%, and Mary Ann Bartels of Bank of America thinks they will slip to 7%. Using Jeremy's methodology, one would overweight their earnings in the go-go years and then all but ignore their losses this last year as they slipped 78% (and still falling).

Buy and Hope
Stocks that lose money fall in price. That is no mystery. And if you are an index investor, you want to know what the index is going to do, not what just some of the stocks are going to do. If the market cap of Citibank drops by 90%, it is going to affect the index. In Jeremy's system, the positive earnings of Citibank in 2006 would be weighted 10 times more than the losses in 2008. That does not help you assess overall index value going forward.

Further, if you wanted to weight earnings by capitalization and use that number for comparison, you would need 100 years of such analysis to come up with an average trend P/E. Comparing Jeremy's cap-weighted index to aggregate data is simply apples and cumquats. It could be hugely misleading.

Quick aside: AIG has now lost over 99% of its value. It is down to $0.42, yet next week will report a loss of $60 billion, which I admit will skew the data even more. It makes it tough to get a real sense of it all. But even if you ignore last quarter, we are still at high valuations going forward, and as we saw from the previous charts, those earnings estimates are a moving target. They are likely to fall further.

Who might want to use such a different weighting methodology? Someone who was committed to buy and hold, has seen their portfolio trashed, and wants to hold on to some hope that their stock is going to come back. Such statistics are a kind of feel-good narcotic for the buy and hope crowd.

For the last 18 months there has been a parade of analysts, mutual fund managers, brokers, and their kin, telling you that stocks are a reasonable value "today." And they trot out "data" (with lots of charts) which supports their position and then ask you to invest "now."

"The stock market turns up six months before the end of the recession. This recession is already almost the longest, so now is the time to buy." The bullish cheerleaders said that six months ago, they say it today, and they will say it in six months. One day they will be right. Care to make a bet?

Now let's reread the last paragraph I quoted from Peter's Financial Times article.

"... There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realized."

We are in an economic period unlike any other we have faced. I think we are likely to have a long, slow recovery after the recession ends some time (hopefully early) next year. However, to suggest that corporate earnings are going to show the same type of resilience in 2010-2012 that they have after every other recession since WWII is ignoring the macroeconomic picture surrounding the potential for earnings growth. "Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical."

We are in a synchronized global recession. Yes, we will recover, but the causes are not those of the typical business-cycle recession. We are seeing massive debt deflation, deleveraging on a scale never witnessed, a financial industry that has to be rebuilt, and a housing industry that is reeling all over the world. We created a lot of excess in a number of industries. We decimated the savings of a generation that was hoping to retire soon, and now will have to work longer and save more.

This is not a typical recession. And for any analyst, writer, or pundit to trot out past historical data to demonstrate that the stock market is going to rebound at such and such a time and at such and such a pace simply ignores the fact that the future is unlikely to look like the past for at least the next 2-3 years. We are in a brand-new world, macro-economically speaking.

And let me also suggest that when we do get the problems worked out, and we will, the recovery that ensues may be breathtaking in its scope, as the technological changes that will be coming down the pike in the next 5-10 years are simply going to dwarf what we have seen in the past 30. Ray Kurzweil predicts that we will see twice as much change in the next 20 years as we saw all of last century. Think about the implications of that.

Just as we cannot let past performance and wishful thinking blind us to the reality that we confront today, we must not let 3-4 years of a slow Muddle Through world after this recession ends blind us to future opportunity. Projecting the current trends into the long future is nearly always a mistake. And the longer the trend goes, the more complacent (or negative) we get. But trends change. Remember that.

Just because a stock is down by 50% does not mean it cannot go down further. Think back to all the people who said Citi was a screaming buy at $20 or ... (pick a stock!). I want to see earnings start to settle down and maybe even rise. Given the nature of what could be the negative environment for earnings in the second quarter, there could be one more leg to this bear market. Though I must admit that I am surprised we haven't seen some type of tradable rally. I thought the money coming back into the market from hedge fund redemptions might have been a boost, but evidently it has not been. Caution is the word today.

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John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore