SERIOUS MONEY:Current stock valuations compare unfavourably with the overvalued market of 1987, writes CHARLIE FELL
US STOCK prices dropped more than 5 per cent on Friday, October 16th, 1987. The third consecutive daily decline took place on record volume and brought the cumulative losses over the three-day losing streak to about $200 billion (€134 billion) or 10 per cent. The major stock price indices closed the week on little more than 12 times analyst estimates of one-year forward earnings, or three multiple points below the excessive valuation that was registered at the market high seven weeks previously.
Stock prices appeared to have erased the rich valuations that were apparent in late August, yet events over the weekend conspired to send values sharply lower at the open on Monday morning. Heavy selling continued throughout the trading session and by the close of business on Black Monday, the major averages had registered losses of almost 23 per cent or roughly $500 billion.
More than two decades later, and following a record-breaking advance of almost 60 per cent from the bear market low in early March, stock prices trade on 15 times one-year forward earnings, or three multiple points above the valuation that was recorded on the eve of Black Monday. The stock market is priced at almost 28 times, trailing 12-month earnings today or 10 multiple points higher than 22 years ago, and more than 17 times trend earnings as compared with a multiple of less than 15 prior to the crash of 1987. Consequently, it is difficult to argue that stocks are anything other than expensive when judged against the supposedly overvalued market of 22 years ago.
The diehard bulls will argue that the comparison is unfair because, unlike the 1987 mid-cycle earnings expansion, corporate profits are currently severely depressed and at a recessionary trough.
However, today’s valuation at 28 times trailing earnings is higher than the multiple that prevailed at the earnings nadir in all but one of the previous recession-induced bear markets. The exception is the fourth quarter of 2001, when stocks traded at almost 30 times trough earnings though the major indices had not yet bottomed and continued to struggle through most of 2002 and early 2003, at which point the multiple had dropped below 18 times. During the previous eight recessionary bear markets, the median multiple at the earnings trough was 15 times.
The forward earnings multiple offers little help to the perma bulls. Bottom-up analyst estimates project a more than 30 per cent increase in earnings per share over the next 12 months to $73, or almost $10 above realistic estimates of long-term earnings power. Typically, it takes two to three years from the recessionary trough for corporate profits to surpass long-term earnings power but the latest bout of “new era” thinking sees analysts believe that corporate America can achieve that feat this time around by summer 2010.
This majestic jump in corporate earnings is supposed to occur in the face of record low capacity utilisation and a double-digit unemployment rate.
Revenues are projected to grow 9 per cent amidst weak demand and a general lack of pricing power while margins are forecast to climb two percentage points which clearly depends on further aggressive cost containment on top of existing action that has already served to weaken top-line demand. Corporate America, which has already endured a record four consecutive quarters of negative revenue growth, simply can’t cost-cut its way to prosperity in aggregate.
Both the historic earnings and analyst projections are operating numbers, or profits before exceptional and extraordinary items. Valuation analysis conducted in this manner is flawed. Operating earnings overstate corporate profitability because write-offs are a normal consequence of the cycle. These “once-off” charges have averaged roughly 15 per cent of operating earnings over the past 20 years or roughly one to two US cents for every dollar of existing capital stock. Applying a 15 per cent haircut to the analysts’ rosy projections yields an earnings number of $62 a share for a forward multiple of 17 times.
The final weapon in the bulls’ arsenal is the argument that interest rates are historically low and therefore supportive of current valuations. It is beyond dispute that nominal interest rates are low compared with the yields available on treasuries historically. However, the current 10-year treasury yield adjusted for long-term inflation expectations is roughly 2 per cent, or in line with historical experience. Furthermore, the yield spread on Baa-rated corporate debt at close to three percentage points is more than 75 basis points (three-quarters of 1 per cent) higher than what is typical at an earnings trough.
The 22nd anniversary of Black Monday is just a weekend away and though a repeat performance is unlikely, the record shows current valuations compare unfavourably with the oft-cited overvalued market of 1987. Nevertheless, investment managers continue to argue that stocks are attractive and plan to increase allocations on setbacks.
It appears that no lessons have been learned from the calamitous performance of recent years. Astute investors, however, will heed the words of Warren Buffet when he quipped that, “price is what you pay, value is what you get”, and reduce equity exposure on strength.
charliefell@sequoia.ie
