To properly understand the price-to-forward operating earnings ratio, you have to recognize that operating earnings exclude a whole host of charges - what some observers correctly call "recurring non-recurring" charges. These include large and often quite regular losses that the companies deem, often on the thinnest basis, to be detached from their core business - even if the losses are directly related to their core business. Items like enormous asset writeoffs come to mind. Moreover, the "forward" means that these are year-ahead analyst estimates, which are typically substantially higher than trailing 12-month reported earnings.
Think of it this way. Suppose your poodle is 40% overweight. Someone sells you a scale where every pound shown on the dial represents 1.4 pounds of actual weight. Guess what? Your poodle will step on that scale, and the dial will pleasantly report that your dog is at its ideal weight. That may be comforting if you don't like to face reality, but the truth is, you've still got one sick puppy.
When you hear analysts say that the historical average P/E ratio is about 15, you have to recognize that this is the normal P/E based on trailing 12-month earnings after subtracting all writeoffs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990's bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.
A final observation is crucial. Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history.
Bill Hester provides more insight on Wall Street earnings projections in his latest research piece Wall Street Earnings Expectations Ignore Economic Divergences (additional link below)
Economic risks continue
From our perspective, we continue to observe pointed recession risks. I'll emphasize again that our Recession Warning Composite (see the June 28 comment Recession Warning) is based on the observation of multiple conditions simultaneously, and is not driven by any single indicator. Given that I've made two, and only two, recession calls over the past decade (October 2000 and November 2007) based on this Composite, and we've always and only observed such signals during or immediately preceding other post-war recessions, I don't take the present indications lightly, and I don't like the odds.
The consensus of economists has never correctly anticipated a recession, nor have Ben Bernanke or Alan Greenspan, nor to my knowledge did any of the analysts currently assuaging investors that further economic weakness is unlikely. With regard to the ECRI Weekly Leading Index, I'll emphasize again that it nicely leads the ISM Purchasing Managers Index with a lead time of about 13 weeks. As a result, its inclusion in the composite produces more timely signals than the ISM. The WLI growth rate dropped again last week, to -8.3%, from -7.6% the prior week, which is consistent with a decline in the Purchasing Managers Index to about 44 over the next few months.
Still, it bears repeating that I am not reporting the ECRI's outlook on recession risk, but instead the implications of including the ECRI data within our broader Recession Warning Composite. The recession call by the ECRI in March 2001 admirably matched the exact beginning of that recession, but stocks had already declined precipitously by then. The call in early 2008 trailed the beginning of the most recent recession, and again followed substantial losses in the S&P 500. I note this because although the ECRI has a commendable record, and is generally decisive well before the economic consensus, it's important to recognize that deep stock market losses can precede even the best recession forecasts.
Among other views that should be taken seriously are those of Meredith Whitney, who has a much clearer understanding of credit issues than the majority of observers, and is always thought provoking. Not surprisingly, her views haven't changed a great deal over the past few months, but given that investors appear to acquire and abandon economic concerns on nearly a weekly basis, some consistency regarding the larger picture may be helpful:
"The government's involvement made the banks do really well. The government's out of the pool now, and we're on our own. The states that produced the most GDP are those that produced the most real estate, and I think we're in for a very rough second half. And here's where I would have never imagined... what happened over the past year-plus is that the government and the banks have provided a lot of mortgage modification programs, and consumers have been smart enough to say ok, if I wait, I'm going to get a better deal on a modification in 2, 3, 6 months. So I'm going to pay the things I need the most - my credit card bill, my auto bill, and even my home equity loan bill to a certain extent, and they've been not paying their mortgage bill.
