Friday, February 6, 2009

But the Market's Cheap

The cats over at Comstock Partners do excellent work. Their post this week, Earnings Are Collapsing, which I have re-printed below, addresses the fundamental argument that stocks are cheap on a valuation basis. Please read it and refer to it when someone comes on pom pom TV and tells you that stocks are the buy of a lifetime.

Comstock Partners, Inc.

Earnings Are Collapsing !!!
February 05, 2009

We believe that stocks will not begin a new bull market until valuations decline to levels reached at the bottom of past secular bear markets. In order to be able to make such comparisons, the method of tracking corporate earnings at this time must be consistent with the methods of previous periods.

At the risk of "beating a dead horse" we are incredulous as to why Comstock seems to be the only ones that are of the opinion that Wall Street is getting it wrong again by focusing on "operating" earnings. We were published in Barron's twice about the subject of "reported" earnings vs. "operating" earnings. As we have stated many times in these comments, "reported" earnings are Generally Accepted Accounting Principals (GAAP) earnings and "operating" earnings are GAAP earnings that "exclude write-offs". Isn't it clear which earnings make the most sense? Why would anyone continue to use earnings that don't include "write-offs" (especially when the write offs are so consistent) and the fact that they only came into existence in the late 1980's and gradually became the main earnings used by Wall St. (as stocks rose to more and more overvalued levels)?

By the late 1990's as reported earnings valuations reached unprecedented high levels, the switch to "operating" earnings became universal in order to justify the valuations. Also, the spead between the "operating" and "reported" earnings became wider and wider as more and more companies had "write-offs" that the CFOs were extremely pleased to not have to include in their earnings release. In fact, the "operating" earnings that "exclude write-offs", are now double the GAAP earnings (until yesterday and we will get into that later). Operating earnings estimates for 2009 were, until yesterday's revisions, around $80 a share for the S&P 500 and are around $40 for "reported" earnings (see the NDR attached chart). This essentially means that with the S&P 500 selling around 840, the market is trading at a very inexpensive 10 times "operating" earnings. However, on the basis of "reported" earnings which were used for the past 90 years we would be trading at close to a very expensive 20 times earnings. If you check out the charts on "Limbo, Limbo How Low Can it Go" on our home page you will see that using the last 12 months of "reported" earnings, P/E ratios generally bottomed at around 10 times earnings and peaked at around 20 times. These are all charts provided by NDR Research. The only exception to this occurred during the late 1990's where valuations reached double this level (and this is why almost all of Wall Street converted to "operating earnings" to justify the valuations). If Wall Street wakes up to focusing on "reported" earnings, we believe the market would decline substantially.

The reason we are dealing with this subject again this week is because the "operating earnings" estimates which can be verified by clicking on the following link shows that the latest "operating" earnings estimates were revised down to about $69 form the previous estimate of about $82. In addition the 2008 reported number was lowered to about $35. We wrote this comment earlier this week and predicted at that time that the earnings would be revised down since they were "under review" for the past two weeks. This downward revision, however, is probably the largest decline on record. The only way to observe these downward revisions would be to do what Comstock does periodically --- check out this same website and add the latest four quarters to see what the earnings estimates were at the time (excel speadsheet attached to see the downward revisions throughout 2008 of the 2008 and 2009 earnings estimates for both "operating" and "reported" earnings).

Again, we are trying to put the most optimistic light possible on a very dreary subject. If we were to put a trough multiple on trough earnings of say $40 (or even lower as we expect another downward revision) we could come up with a very low target level on the S&P 500 if the bottom occurred this year. However, since we want to put the most optimistic spin on the markets as possible, we are using our trendline "reported" earnings (a way of smoothing out the last 9 years of earnings over the past two business cycles). Our 2008 trendline earnings are now closer to $60 than the actual $35 estimated by the S&P analysts (the fourth quarter of 2008 was revised down to -$314 this past Tuesday from a +$6.85 estimate for a swing of $10---this is the first negative quarterly earnings on record), while our 2009 smoothed earnings are $64 compared to an actual $42 estimated by S&P.

Therefore, even on our conservative $64 trendline estimate for 2009, a trough P/E of 10 would result in the S&P 500 declining to around the 640 level-and it could be worse if investors ever focus on the actual reported earnings number.

Good speculating to you all and never forget that "an investor is a speculator who made a mistake and will not admit it".

Open Positions:
Long 2 units Ultrashort MSCI EAFE ticker EFU @ $89.80 stop at $89.80
Long 2 units Ultrashort S&P500 ticker SDS @ $69.80 stop @ $66.15
Long 2 units Ultrashort Real Estate ticker SRS @ $53.80 stop @ $47.18
Long 1 unit US Gasoline fund ticker UGA $21.85 stop @ $19.58
Short 2 units Darden ticker DRI @ $27.15 stop @ $28.70
Short 1 unit Wells Fargo ticker WFC @ $20.20 stop @ $20.20
Short 1 unit JP Morgan ticker JPM @ $27.35 stop @ $27.35

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