Forget the Spin--the Market is Overvalued Comstock Partners, Inc. Thursday, June 15, 2006
Now that that the market has shown signs of reversing to a significant down-trend, the bulls argue that the downside is limited since P/E ratios are reasonably valued or even undervalued. We strongly disagree. Despite the lessons that should have been learned from the 2000-2002 bear market, the Street, in calculating the P/E ratio, continues to use forward-looking operating earnings and fails to take into account the fact that current earnings are far above trend and that earnings have always fluctuated above and below the historical mean.
A typical Street analysis goes as follows: “Estimated S&P 500 earnings this year are about $84. Therefore, assuming a fair market P/E of 16-to-17 times, fair value should come to 1344 to 1428, well above current levels.” In our view that is a seriously flawed calculation. The estimate of $84 is operating earnings for 2006. Let’s not forget that there are no accounting standards to determine operating earnings. What expenses are included or excluded is purely discretionary, and therefore inconsistent from one company to another. Although the expenses excluded in calculating operating earnings are supposed to be non-recurring, write-offs for a large number of companies occur year after year and are not truly non-recurring. Prior to the mid-1980s there was only one generally recognized earnings number, and that was so-called “reported” or GAAP (Generally Accepted Accounting Principles). Over the last 80 years the average P/E on GAAP earnings has been about 15.9. Since the use of operating earnings became popular P/Es on operating earnings have averaged only about 86% of the P/Es on reported earnings.
We also don’t like the idea of using forward earnings since the estimate is almost always wrong, often by significant margins and usually on the high side. Historically the P/Es on forward-looking reported earnings have averaged only 75% of the P/Es on 4-quarter trailing reported earnings.
In addition, over long periods of time, S&P 500 earnings have grown at an average annual rate of 6%, and actual earnings have continually fluctuated above and below this trend. In fact, since 1927 actual reported (GAAP) earnings crossed the 6% trend line 18 different times. For the year 2006, trendline reported earnings are about $62.30, about 21% below the Standard & Poor’s estimate of $78.94 for actual earnings.
In our view the current fair market value of the S&P 500 is 15 to 16 times the trendline number of $62.30, meaning that fair value is from 935 to 997. Keep in mind, however, that at major bear market bottoms P/Es have usually fallen into a range of 8 to 12. Should this happen, the range could decline to between 750 and 500. At its close today of 1256 the index is still selling at 20 times trendline earnings, a number that has seldom been exceeded before the late 1990s bubble. Although anything can happen in the stock market, it seems that the upside potential is exceedingly small while the downside risks are great. With all of the other problems facing the market that we have discussed numerous times in previous comments, investors should be particularly cautious in relying on a so-called “reasonable” P/E to protect them from serious financial damage.
Market Data 
Markets 
AI
