Downunder Daily : Back to 1907
One reason for strategic caution on equities is that
consensus earnings expectations appear too high. Forecasts
imply that the earnings declines will prove to be largely cyclical. My view,
however, is that a combination of a tepid recovery and structural change means
earnings will not quickly rebound to prior levels. Consequently, Wall Street is
not cheap. For now, of course, that may not matter...
The earnings bubble has spectacularly burst.
Earnings have fallen over 80% from their peak. Based on Standard & Poor's
earnings, corporates earn as much now as they did in 1907, after adjusting for
inflation (Exhibit 1).
These GAAP earnings include all the
write-downs. No one expects that the write-downs will continue indefinitely.
That is reflected in valuations: Wall Street is now trading on a P/E never seen
before (Exhibit 2). This may be an old-fashioned way to look at the market, and
I'm not advocating using this as a tool, but a couple of points are worth
noting:
First, the extraordinarily high P/E is a
testament to investors' views that much of the earnings decline is temporary.
It is usual for equities to look through temporary earnings set-backs - which
is why the trailing P/E series tends to peak in bear markets, not bull markets.
But the extent of the current spike implies that a greater-than-usual amount of
the recession decline in earnings will be quickly restored in the recovery.
Second, a high P/E when earnings are low
should be the counterpoint to a low P/E when earnings are high. In this cycle,
however, the lowest P/E was 17, which compares to the long-term average of 15.
In short, the cycle-average P/E has been very elevated relative to history.
This isn't reflected in the now-usual reliance on 'earnings before bad stuff'
metrics - confirming that today's P/E ratios aren't the same as they used to
be.
The question, of course, is the extent to
which earnings will recover. We are less optimistic than the market is. Our
first reason for caution is the cycle. Morgan Stanley US economists Dick Berner
and David Greenlaw are expecting a reasonably moderate recovery for growth, and
hence likewise for top-down earnings (Exhibit 3).
On top of the cyclical view is that several
of the factors behind the extended upsurge in profits are unlikely to return
anytime soon.
First is the super-cycle in Financials. The
top-down earnings series for Financials excludes write-downs (and 'write-ups',
or capital gains), so provides a sense of underlying earnings. These boomed
through the super-cycle; have now bust - and are unlikely to get anywhere near
the prior peak, in my view.
Second, corporates benefited from the
willingness of consumers to increase their spending, without commensurate
increases in their pay. More accurately, consumer spending share of GDP
increased while both wages and total income shares stagnated. This was a
tailwind for profits. But it was only possible because the household sector was
reducing its saving rate. Now the saving rate seems headed higher, not lower.
Third, the strength in earnings was enhanced
by stock buy-backs, which meant that EPS out-paced earnings growth through this
cycle. The period of rising financial leverage seems likely to be coming to a
close.
The now much-used Graham and Dodd P/E is
designed to smooth over relatively short-term earnings fluctuations. It
suggests that the market is around the long-term average (it is now at 15.5
times, versus a long-term average of 16.4). However, many of the trends that I
think are reversing have lasted long enough to affect even the G&D P/E.
Earnings over the past 10 years for the S&P 500 have been around 40% higher
than the long-term average, as a share of GDP.
One way to measure value is to assume that
profits mean-revert as a share of GDP, and calculate a P/E based on that
implied earnings series. As Exhibit 5 shows, this measure used to be highly
correlated with the G&D P/E, up until around 2001. (In other words, the
G&D P/E implicitly assumed that profit share mean-reverted.) The
alternative valuation metric - which explicitly assumes profit share mean
reversion - is now on 19 times. Not cheap.
None of this may matter in the near term. The
market's vulnerability is the medium-term earnings forecasts, and there's no
immediate catalyst for those numbers to come down. It may take several years
for investors to realize that the earnings bubble that took 20 years to inflate
is finally over.
I'm in Asia next week, so next DuD will be on
18 May. GM
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Coverage Universe |
Investment Banking Clients (IBC) | ||||
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21% |
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Total |
2,223 |
593 | |||
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