Sandcastles in the Sky

 | Nov 27, 2012 | 1:00 PM EST
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The other conversation of interest around Chez Melvin this past weekend -- in addition to growth-vs.-value debate I discussed Monday -- was the current level of the stock market. I don't try to predict market direction, as I have found this activity to be hazardous to my wealth. However, I do enjoy the debate. It also makes sense to pay some attention to rising risk levels, as identified by a lack of safe and cheap stocks. Many folks try to discern whether the stock market is cheap or rich, based on valuation, and then invest accordingly.

This past weekend, one such individual made the bold statement that the stock market was very cheap, and that it should be bought with great abandon. When challenged by others in the conversation, he told the group that the stock market was well below historical norms, based on forward earnings estimates, and that it could appreciate by more than 20%.In my usual kindly fashion I stated that this was one of the more foolish things I have ever heard, and a dangerous form of analysis.

Predicting the direction of the market via forward-price-to-earnings ratios, or earnings estimates, is a fool's errand at best. Those estimates will change constantly as we go through the coming year, and they cannot be used as a basis for any sort of valuation or prediction. I have studied forward-P/E ratios on several occasions and have found them to be predictive of nothing at all.

Let's take a second and dissect the earnings estimate for the S&P 500. When I look at the index estimates, I see growth is projected at about 10% overall, and financial-sector names are estimated to see an earnings increase of a little over 10%. Much of the earnings of the larger banks this past year came from the release of loan loss reserves, and I have a hard time seeing how that can continue into 2013. Since 2010, something along the line of one-third of bank earnings have come from the release of loan-loss reserves. The rising costs of regulation, and increased restrictions on trading activities, could also cause the estimates to come in well below the always-optimistic analyst expectation.

For instance, one of the largest estimated increases is in consumer discretionary spending, which is projected to climb 15% -- and I just don't see where 2% gross-domestic-product growth translates into that. In the third quarter, stocks in this sector reported earnings that were basically flat on a 1% sales increase. If we hit the much-discussed fiscal cliff, the consumer discretionary sector could well see prices drop year over year. It is almost certain that, should the GDP contract due to political and economic issues, any gains in the materials and energy sectors would be eliminated as well.

Yet all of those statements can be stood on their head and viewed form a bullish angle, as well. Things could go better than expected with Congress and President Obama, and it's possible they'll reach an agreement that satisfies consumers and business -- and that we'll see stronger earnings as a result. If Europe gets its act together, and we begin to see a global economic recovery, increased demand could be a boon for energy and materials. It is almost impossible to tell how 2013 will play out, and that renders the estimates pretty much worthless.

If we look at the trailing 12-month P/E ratio, it is currently at a little over 16x. If the economy were growing at 4% a year, the market would be reasonably priced, per the Graham P/E formula. But it isn't. The growth rate is estimated at 2% and, at that level, the right ratio is around 12.5x. For the market to be fairly priced, the S&P 500 would need to pull back to 1100 or so. Assuming we're set to hit the fiscal cliff and see flat to negative growth, the fair price of the S&P, based on earnings, is a gut-wrenching 750.

If you look at the 10-year average earnings, the Schiller P/E ratio is at 21x -- about 30% above its historical average. This P/E has been lower than the current level 80% of the time since 1928. A recent study from Cliff Asness, the noted quantitative-analysis fund manager, concluded investors should vastly lower their expectation or returns based on the index multiple, not just for next year but for the next decade. The ratio can stay high for an extended period, but it would be a mistake to ignore it at extreme levels.

Next month we will start to see a steady flood of 2013 stock-market predictions. The airwaves will be filled with well-dressed men and women making highly confident predictions about what the stock market will do for the next 12 months. Those who tell you the stock market is cheap based on projected earnings are just building sandcastles in the sky, and should be ignored at all costs.

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