Bulls' optimistic analysis does not stack up

SERIOUS MONEY:THE THIRD quarter reporting season has begun in earnest and the diehard bulls – who failed to reduce equity weightings before the recent sharp decline – are hopeful that a renewed focus on corporate profitability will push share prices higher. Indeed, some of this motley crew have argued publicly that stock markets have rarely looked more attractive given current levels of earnings and interest rates.

However, the analysis provided to back the argument is flawed, and could potentially prove costly to an unsuspecting investor as a more thorough investigation reveals that US stock prices are anything but cheap.

The optimists’ continued focus on current and one-year forward earnings is difficult to fathom given that neither figure is a measure of the stock market’s sustainable earnings power. In this regard, Benjamin Graham, the father of value investing, noted in his classic bestseller, The Intelligent Investor, that “In former times, analysts and investors paid considerable attention to the average earnings over a fairly long period in the past – usually from seven to 10 years. This average figure was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company’s earning power than the results of the latest year alone.”

Adjusting for the profit cycle is crucial in performing a proper valuation analysis if the output is to subsequently prove a reliable measure of value. The use of current or one-year forward earnings is likely to subtract from investment performance because the resulting price/earnings multiple may well appear low and inviting at the peak of a profit cycle, while the multiple is likely to be anything but compelling at an earnings nadir.

Stock prices are forward-looking and as a result, this approach, which continues to be widely used by the stale bulls, is likely to see investors move in and out of the stock market at exactly the wrong moment.

In this regard, it is important to note that the current profit upturn has proven particularly robust and 12-month trailing earnings are likely to have surpassed the pre-recession peak during the third quarter. However, irrespective of whether the earnings figure employed is the dubious operating number before all the bad stuff, or the more appropriate figure after exceptional and extraordinary charges, current earnings are more than 40 per cent above their 10-year average.

Regression analysis reveals that the ratio of current profits to 10-year average earnings explains almost 50 per cent of the change in corporate profits over the subsequent three to five years, and the results are statistically significant. The output suggests that investors can reasonably expect nominal earnings to flatline at best over the next three to five years, and decline by roughly 15 to 20 per cent in real terms.

Data published in the national income and product accounts corroborates the results obtained using information in companys financial accounts. The after-tax corporate profit share of national income reached a post-second World War record of 14.5 per cent during the second quarter, as employee compensation plummeted to a new low.

The evidence reveals that such a situation has rarely been sustained for long in the past once the labour market began to tighten. This time around, the decline in workers’ purchasing power – combined with ongoing balance sheet deleveraging – is likely to undermine effective consumer demand and, ultimately, squeeze margins via sluggish revenue growth. The bulls will maintain that this time is different because of the greater share of earnings captured by foreign operations but, since the primary source is Europe, the point seems moot.

Investing in equities close to an earnings peak has rarely proved a successful strategy and today, despite the naive bulls’ protestations, valuation multiples provide little room for manoeuvre. The stock market is currently trading on 18.5 times 10-year average operating earnings and the multiple using normalised reported earnings is more than 20 times. Both these measures are several multiple points above their historical norms and as a result, current valuations do not provide any margin of safety to investors.

Of course, the bulls will argue that current valuations are more than justified given the low yields on 10-year treasury bonds. Once again, the analysis is flawed given the recent historical evidence that shows bond yields and price/earnings multiples have been moving in the same direction for more than a decade. Indeed, the coefficient of correlation has been more than 0.75 since 1999, and the results are statistically significant.

The seemingly perverse relationship is easy to understand when 10-year yields of little more than two per cent are viewed through the lens of rising deflationary risks. The historical evidence reveals that a demand-driven deflation leads to greater economic and earnings volatility and, as a result, individuals require additional compensation for investment in stocks ie, lower price/earning multiples.

Record corporate profitability and ultra-low interest rates are being touted by the bulls as reasons to buy stocks. Astute investors will note that the analysis is deeply flawed and ignore the potentially misleading advice accordingly.

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