Friday, March 12, 2010
Stocks Are not Cheap, No Matter how a Chart Is Drawn
As markets float upward following the path of least monetary resistance, the argument is made that the "market" is "cheap".
Today's Chart of the Day implies that P/E (price to earnings) ratios are comparable across the decades.
Unfortunately, that is not so. The greatest reason this is not so is the recent introduction of "non-recurring" earnings that are not presented according to Generally Accepted Accounting principles. In other words, today's earnings are often overstated relative to prior periods' earnings, thus falsely depressing the P/E.
This is one reason why dividend yields are so much lower than historical yields, despite alleged payout ratios that are much less different than before. (Another reason is the weaker financial strength of dividend-payers; decades ago there were numerous AAA-rated companies, now even though the economy can support more companies and they are bigger, there are hardly any.)
This blog recently pointed to Teva Pharmaceuticals, which is a litigious primarily generic products company, as a high-quality large-cap company that arbitrarily has decided that when it pays out hundreds of millions of dollars to brand companies for patent infringement or other patent-related costs such as out-of-court settlements, those dollars are not costs for purposes of earnings presentation.
It was not long ago that GAAP was the standard and only way earnings were presented. It was up to analysts to make the case that perhaps the stock price was too low due to GAAP peculiarities.
The problem now is that the financial community hardly ever goes beyond "earnings" in valuing stocks, unless it wants to highlight potential future earnings or earnings growth rate. Dividend yield and especially book value or asset value are forgotten. But the problem with pointing to non-GAAP "earnings" and excluding patent costs or the infamous "restructuring" costs (which pretend that closing obsolete factories is not a normal, recurring cost of doing business) is that the money is still not there.
A person can pretend that a sudden business or investment loss, or adverse IRS ruling is non-recurring. But a lender does care about income but also should care about net worth.
According to both the cyclically adjusted P/E and "q" (or Tobin's "q" ratio), stocks are about 50% overvalued. These two are favored by Andrew Smithers, a noted economist whose research has shown that these two measures are the two valid methods of measuring fair value in the stock market.
Because of the nature of those two measures, they cannot change quickly. A good year for earnings or real corporate wealth accumulation only changes them somewhat. Thus a 50% stock market fundamental overvaluation means that investors should be extra wary when a free chart purports to suggest that the "market" is historically "cheap".
Virtually all financial assets are expensive.
Choose your flavor. My flavors include financially strong companies that do not routinely present non-GAAP "earnings" with any prominence that have strong charts and strong real earnings trends, preferably with dividends, and with historically average or better than average fundamental valuations; gold for long-term safety; cash because everything appears too rich; and Treasuries because of the Japan scenario.
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