Your Economy (No Politics)

[Bullwinkle]

Market Based on Earnings & the Valuation of Earnings
by Comstock Partners, Inc.
Thursday, September 22, 2005


Hurricanes and Category Changes are Secondary

Our regular readers know that we believe the stock market has a very strong correlation with corporate earnings and the history of the valuation of those earnings (Price to Earnings). We believe that currently the stock market and projected corporate earnings are in great variation with their historical relationships.

Our contention is that in the late 1990s we experienced the greatest financial mania in history, where the valuations (PE ratios) placed on the S&P 500 earnings rose to 40 times. This was approximately double the valuation levels reached at prior market peaks. History shows that after normal market peaks-- valuation levels of 20 times earnings were followed by bear market trough valuation levels of less than 10 times earnings (see Limbo, Limbo, How Low Can It Go? on our home page).

Since the reported earnings of the S&P 500 are estimated to be in the range of $70 for 2005 as well as 2006, we believe the S&P 500 will eventually reach 700 or less if the bear market troughs before the end of 2006 and the earnings estimates are accurate. We don’t necessarily believe the bear market will trough before the end of 2006, and we also don’t necessarily believe the earnings estimate of $70 per share for the S&P 500 will stick.

The history of the S&P 500 earnings shows that they peaked at $50 per share in 2000 (as demonstrated in the attached chart). In addition there were no estimates of a decline in these earnings in 2001. However, what actually happened is that the earnings were halved to $25 per share in 2001. Since then, the earnings increased at a very rapid rate to where they are now 40% higher (at $70) than the peak achieved in 2000 at $50. This represents a 30% compounded growth rate since 2001. The question is whether this strong growth will continue?

The reasons that we feel that this strong growth of earnings will not continue are fourfold. One, we don’t believe the profit margins that have reached their historical peaks will be able to sustain those levels. You can see from the attached chart that once they reach these historic peaks they revert back to the mean and below. You can also see that the profit margins were at these same extremes in 2000. Secondly, the consumer has leveraged their consumption relative to wealth and income to extreme levels which cannot be sustained. Thirdly, the housing bubble which has supported consumption in the past few years is close to bursting and will leave in its wake a reverse wealth effect and a severe reduction in the ability to use one’s home as an ATM machine. The fact that the consumer savings rate is negative combined with no appreciating asset to leverage against doesn’t bode well for continued consumption. The fourth reason is the monetary and fiscal stimuli which were in force during most of the strong earnings growth are no longer helping. The monetary stimulus has been reversed for over a year as evidenced by this week’s 11th rate rise over the past 15 months. The fiscal deficits have reached such extremes that the Democrats and Republicans have neared a bipartisan agreement that enough is enough. It may continue to worsen in 2006 due to the Katrina disaster and pending Rita disaster, but that type of stimulus is not positive. If it were, then we could stimulate the economy by having bricks thrown through every window in order to replace those windows.

If we are wrong in our assessment that 2006 will generate lower earnings, we still could get price targets on the S&P 500 of 700 or lower-- even if the bear market trough occurs next year.

GAAP EARNINGS--Could Be Peaking

Profit Margins Back to Peaks of 1966 & 2000


© 2005 Comstock Partners, Inc.