Shares aren't cheap - they have much further to fall
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Associate Editor
David Stevenson Feb 27, 2009
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US stocks are heading in just one direction
There must be some bargains in the stock market by now. After all, surely the more share prices fall, the “cheaper” they get?
Sounds logical. But there’s just one problem – US data shows that company profits are falling even faster than share prices. And in fact, if you look at the real money that companies are making – that is, profits after all the excuses and excluded items and nasty bits have been thrown in – the picture is even worse.
And as politicians’ recovery plans look set to fail, it all points to shares in the States (and that means over here too), falling a great deal further...
How shares are becoming more, not less, expensive
A company’s share price generally consists of two basic elements.
The first is the after-tax profit made by the business, divided by the number of shares in issue. That’s known as earnings per share (EPS).
Then there’s the valuation that the market places on those earnings – otherwise known as the price to earnings (p/e) ratio.
So when shares plunge as they have recently, at least one of these variables is being reduced. Either profits are crumbling or the valuation’s tumbling. Or maybe both.
America’s S&P 500 index has now halved from its October 2007 peak. But what’s remarkable is how fast profit forecasts are being slashed. Since the start of November 2008, the S&P 500 index has sunk by some 22%. But during that time, the ‘experts’ have slashed their forecasts of ‘operating earnings’ for 2009 – i.e. profits before income and tax, and excluding ‘one-off’ items – by around 28%.
In other words, the market’s p/e is actually rising, despite prices falling. You are paying a higher share price to buy fewer earnings. So shares are becoming more, not less, expensive.
That’s bad enough. But there’s yet worse news.
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As Charles Minter at Comstock Partners points out, US investors are watching the wrong profit gauge. Instead of monitoring operating earnings, they should be looking at ‘reported’ earnings. After all, these are the profits that companies actually make, as they include all those one-off, so called ‘exceptional’, items that companies like to hide away.
Why? Think of company profits as a game of golf with a difference. Just looking at operating profits is like playing a round where you’re allowed to get away with all your blunders. Like you keep slicing it into the trees, but your ball keeps being replaced on the fairway, and everyone pretends nothing’s gone wrong.
But as any golfer knows, it never works like that. ‘Exceptional’ items have a habit of recurring over and over again.
Why does this matter so much? Because since early November 2008, estimates for 2009's reported earnings have plummeted by about a third. So on this basis, US shares are getting even more expensive than when measured by operating profits. So much so, that on the charts produced by Ned Davis Research going back to the mid 1920s, the S&P 500 is still well above its 25-year average valuation multiple of 21 times.
The really bad news for stocks
The really bad news for stocks is that big bad bear markets like this one generally cut overall p/e ratios to near single-digit levels.
In short, US shares could have much further to fall. This week, Minter caused a stir by suggesting the S&P 500 could still plunge by a further 60% - yes, sixty percent – if the low point of valuations in this bear market turns out like the other really nasty ones.
Too gloomy? Maybe. But other analysts are now catching up quickly. Yesterday David Kostin at Goldman Sachs slashed his own S&P 500 earnings forecasts to factor in a 56% peak-to-trough profit drop. At the very least, a further 20% US market fall looks on the cards.
And that sort of stock damage would be bound to cross the Atlantic. London shares have moved step-by-step with their American cousins since the bear market started. They’re not going to ‘decouple’ now.
The US economy's 'debt fatigue'
But, you ask, won’t new president Obama’s “stimulus packages” save the day?
Er… no actually. The US economy’s got ‘debt fatigue”.
What’s that? Minter explains that in the 1950s and 1960s, it took $1.50 of new borrowing to create an extra $1 of annual output. But the trouble is that America has since massively overdosed on debt.
Years of “financial mania” gave the impression that times were good, says Minter, but “the economic strength over the past 13 years was all a mirage”. Now the US credit mountain has grown to a staggering $52trn. To put that into context, it’s at a highest-ever level of 3½ times GDP. So the strain of making the repayments means that creating an extra $1 of GDP these days requires an additional $3.5 of borrowing.
It’s like running ever faster just to stand still.
Further, $14trn of that debt is owed by American consumers. And with house prices in freefall, they’ve already got far too much debt on their plates to be able to take on any more. Nor can the country now afford a stimulus plan big enough make any real difference.
That’s despite Mr Obama’s projected budget deficit of $1.75trn, the biggest since WWII. Yes, there’ll be plenty of headlines about the politicians’ latest piece of interference, and their new ideas about how to spend lots of money they don’t have. But at best, these will only delay the inevitable.
Which is that for a proper recovery to take place, debt has to be paid down, savings have to be rebuilt, and asset prices have to fall until they’re ‘cheap’ again. And that’s going to take years.
That’s not to say that investors can’t make any money. They’ll just have to be a lot more selective to do so. In the current issue of MoneyWeek, we look at one group of companies that should be able to profit from a share of the Obama stimulus package. If you’re not already a subscriber, get your first three issues free here.
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