THE BIG PICTURE
Last Update: 16-Apr-12 09:13 ET
Bearish Arguments to Ignore
Last week's Big Picture article laid forth the rationale for expecting difficult market conditions over the next several months. There are legitimate concerns. There are also vastly overblown bearish arguments. The distinction between the legitimate concerns and the excessive concerns is important.
Our market view is a bit nuanced, so herewith is a quick review of recent Big Picture articles:
February 28, 2011: "The Long-Term Case for Stocks" emphasized our view, held since the summer of 2010, that stocks represent excellent, long-term relative value. This long-term view has not changed.
October 24, 2011: "The Other Side of Sell in May" noted that seasonal rallies often start in November. The article concluded with the statement: "It is not hard to imagine a repeat over the next six months of the 15% gains the stock market posted each of the past two years during the historically favorable November through April period." This was a very contrarian view at that time considering the drubbing the market had taken that summer. The S&P 500 index rose 14.6% from that posting to April 2, 2012.
January 3, 2012: "The Bullish Alternative" laid out the argument that, "There is a much greater chance that the S&P 500 will rise 10% to 20% in 2012 than is widely, if ever, discussed." After a flat 2011, few were making the case for double-digit S&P gains in 2012. There is still a possibility of a 20% year with a late year rally, as the S&P is already up 9% on the year.
March 26, 2012: "Headwinds" argued that first quarter earnings and first quarter GDP could disappoint, and that "It is possible that sentiment will soon shift to emphasize the negatives."
April 2, 2012: "Headwinds Increase" noted that during the April to August period the past two years the S&P 500 index has averaged a decline of almost 10%. We cautioned that the coming months may experience similar turbulence in the markets.
To summarize: our long-term bullish stance is not changed in the least. However, we fully recognize that seasonal patterns and slower earnings and economic growth could cause market turbulence this summer.
If a decline does occur, the bears will take center stage and overstate their case. Below we dissect some of the poorly thought out arguments that are already appearing.
The Bearish Arguments That Are Wrong
Three of the most persistent bearish arguments were highlighted in a recent article on a major financial web site.
The arguments are:
1) Market valuations as measured by Price/Earnings (P/E) multiples aren't low.
2) The 10-year Shiller P/E shows stocks overvalued.
3) Profit margins are high and using a "normal" profit margin shows stocks are overvalued.
The first argument typically notes a current 14 P/E for the S&P 500 as opposed to a long-term P/E of 15 to 16. The current P/E, it is often argued, isn't all that low considering the risks in the market today.
The problem with this argument is simple -- no consideration is given to the current interest rate environment.
The P/E ratio is nothing more than the inverse of the earnings yield (earnings/price, or E/P). And, as any basic financial course will teach, the present value of a financial asset is the future yield discounted to present value. The current and expected future E/P (or P/E) is only half the analysis. Also critical is the interest rate environment that determines the discounting to present value.
No one would ever analyze bond yields without considering inflation. Otherwise, current bond yields would be well below long-term norms, and, on this simplistic analysis, absurdly low. Put another way, the P/E on bonds right now is way, way above long-term trends. It makes no sense, however, to suggest bonds on this simple measure are ridiculously overvalued.
It also makes no sense to look at the P/E on stocks without reference to interest rates.
The current P/E on the S&P 500 is extremely low when interest rates are taken into consideration. This can be seen in the high earnings yield on stocks (the E/P is about 7%) compared to the meager 2.00% yield on 10-year Treasury notes.
The current P/E, when adjusted for interest rates, is extremely low compared to historical levels. Stocks represent outstanding relative value. (For a more in depth analysis of this, please access our Big Picture archive and see the February 28, 2011, article noted above).
To compare the current P/E to historical levels is simplistic and misses half of the analysis in assessing valuation.
Shiller Long-Term P/E
The Shiller argument seems, at first glance, to make more sense. The Shiller P/E looks at the ten-year average in order to smooth out business cycle impacts. The current ten-year P/E is above the long-term average and might suggest stocks are overvalued.
A breakdown of the data, however, shows why this argument should not be used for current investing considerations.
A high P/E is usually taken to mean that prices are too high. However, the reason the Shiller P/E is high right now is that the E (ten-year earnings) is very low.
The E is low because bank earnings were absolutely horrific in 2008 and 2009. Negative earnings in financials pulled overall earnings down so much that there was a major impact on the 10-year earnings number.
The long-term P/E is high not because of long-term underlying trends, but simply because of huge negative bank earnings in 2008 and 2009 that were due in large part to write-offs.
Frankly, we do not feel this is a reason not to buy stocks today. The Shiller P/E has been used as a bearish argument for the past three years and it has been wrong. The high P/E is because of an anomaly in the data rather than a representative long-term trend.
It is reminiscent of 2003, when the as-reported P/E on the S&P 500 was over 30. The P/E was very high because of one, huge write-off at AOL Time Warner for the previous merger. The high P/E was frequently noted as a reason to be bearish. But as soon as the write-off dropped off the back end, the P/E suddenly plunged -- without any change in the fundamentals. The high P/E caused by an aberrantly low E was not a reason to consider the stock market overvalued.
It will be years before the 2008-2009 bank earnings drop off the 10-year Shiller P/E, yet the concept remains the same. It would be a mistake to think that the high 10-year Shiller P/E indicates the 'P' is too high. The high P/E is not due to underlying long-term trends that are smoothed out over time, but rather to one-time huge write-offs to 'E' in a couple of years that distort current valuations.
The Shiller P/E is often a useful tool. It has not been useful the past three years and we contend that it is not useful at present as well.
The Profit Margin Argument
The profit margin argument has some validity but is often presented in an absurd way.
Profit margins are very high and above long-term averages. The argument is often that margins will return to the long-term average, so that average should be applied to today's numbers to get a true read on earnings.
That is absurd. No company is going to suddenly lower prices, or raise input costs simply to reduce margins. Profits are what they are today. Period. That is the basis of the value of a company.
It is very realistic to assume that margins will move towards the long-term average over a period of years. In fact, that is our assumption. That will occur, however, as revenues rise over the coming years, but costs rise at a faster pace.
As this happens, profits will rise even further from today's levels even while margins drop.
This is where that margin argument as presented is often dead wrong. There is a jump in the argument from "margins have to revert to the norm" to "that means lower profits." The connection between the two is often skipped. That is a huge flaw in logic.
Margins are certainly high, and are likely to come down in the years ahead. That will restrain future profit growth, but there is no reason to assess today's companies on anything other than current profits.
What It All Means
All of the arguments discussed above are attempts to undermine the argument that stocks currently represent excellent value. They are all founded on faulty logic or take into consideration only a part of the necessary calculation.
Stocks represent excellent relative value today because the earnings yield is higher than the long-term average, and it is extremely high given the current interest rate environment.
Last week's Big Picture article laid out the arguments for yet another difficult summer for the stock market. Any downturn due to seasonal and temporary factors, however, has to be distinguished from any change in the long-term fundamentals.
Founder and Chairman, Briefing.com
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