We See What We Want To See

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We see what we want to see.

Over my 44 years in the investment business, I’ve seen that statement proven over and over throughout the decades.  It was brought to mind again this morning when I read a report from a reliable, nationally reputed research house.  Commenting on yesterday’s release of the Federal Open Market Committee’s minutes intimating that the Fed might end Quantitative Easing in 2013–far earlier than most have anticipated–the analyst drew a bullish conclusion.  He argued that for the Fed to reach that decision, the economy would almost certainly have to be on an expansionary trajectory.  Such, in fact, would be the conclusion drawn by most analysts, should economic growth improve.  That conclusion is illogical only if one examines the bullish rationale offered by the same firm and many others over the past year or so.  In that time period, as economic conditions weakened in the United States and throughout most of the world, the majority of analysts justified bullish outlooks on the basis of weakening fundamentals prompting the Fed’s expansion of Quantitative Easing and other forms of stimulus. Readers are left to conclude that declining economic conditions are bullish and improving economic conditions are likewise bullish.  Curious!  It tends to expose Wall Street’s perennial bullish bias.

Another frequently stated reason for analysts’ bullish outlooks is current equity valuations.  Most commonly cited is the market’s price-to-earnings (PE) ratio.  Having just reviewed the most commonly employed valuation measures for the S&P 500, I find this a good time to evaluate the investment industry’s bullish outlook.  According to Standard & Poor’s, the PE ratio–using Generally Accepted Accounting Principles (GAAP)–at year-end was 16.4, fractionally below the 17 average since 1926.  Before the mid-1990s, that long-term average was about 14 times earnings.  The sequential bubbles blown by the Fed’s largesse and the disappearance of earnings at the depth of the 2008-09 financial crisis have skewed the number higher.

Most analysts call today’s PE multiple “cheap” or, at most, “fair”.  That designation is only true relative to multiples since the mid-90s.  Investors have made minimal returns over that period.  Comparing today’s multiples to those of a period in which investors made virtually no positive return is a specious comparison.

Analysts also attempt to justify their valuation arguments by looking at today’s index price against forecasted earnings over the next 12 months rather than versus trailing earnings.  As history demonstrates very clearly, “hoped for” earnings are typically overstated and are progressively ratcheted down as forecasts get closer to reporting dates.  Another approach is to remove write-downs mandated under GAAP and compare price against operating earnings, which some wags categorize as “everything but the bad stuff”.  At 16.4, the GAAP multiple is far closer to the high end of the historic PE range than the low end.

Other valuation measures paint a far less favorable picture.  Price-to-dividends, price-to-book value, price to sales and price-to-cash flow look downright scary, except when compared to bubble readings from the period since the mid-90s.  These ratios are all currently above or virtually at history’s great valuation peaks that preceded the mid-1990s, including 1929, 1972 and 1987. Any honest study of today’s valuations demands an acknowledgement that the S&P 500 is historically very high relative to its underlying fundamentals.

Valuations have been excellent long-term forecasters of future stock market prospects.  Over the shorter term, however, they offer little guidance.  In all likelihood, the prospects for 2013 will be determined by investors’ retention or abandonment of confidence in the ability of central bankers to overcome massive debt problems with an unprecedented outpouring of newly printed money.