Overly Optimistic Consensus Plays Greater Fools Game Once Again
The crowd is often right except at market turns. After the turn, the crowd tends to holds on until most previous gains vanish. In a secular bull market, such optimism works out acceptably well. In a secular bear market, rampant optimism is severely punished.
David Rosenberg is discussing the overly-optimistic consensus in a Special Report: A "V"-Shaped Recovery.
One Overvalued Market
There has been plenty of debate over whether equities are overvalued or not, and certainly we would assume that many investors know where we stand on the topic.
On an operating ("scrubbed") basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x.
While we will not belabour the point, when all the write-downs are included, the trailing P/E on "reported" earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble.
It is interesting to hear market bulls talk about how distorted it is to be using trailing multiples that include 'recession earnings' (even though using 'forward' earnings means relying on consensus forecasts on the future and these are rarely, if ever, correct). It is also interesting that the last time the multiple was this high was back in March 2002, again after a huge countertrend rally that deployed 'recession earnings' from the 2001 downturn. If memory serves us correctly, this was right around the time that the bear market rally started to roll over and in fact, six months later, the S&P 500 was hitting new lows and 34% lower than it was when the multiple had expanded to ... today's level!
Even On A Forward Basis, The Market Is Overvalued
Bullish analysts like to dismiss the actual earnings because they are "depressed" and include too many writeoffs, which, of course, will never occur again.
The consensus is usually overly-optimistic, which is why so many analysts love to do their analysis on "forward" earnings since the market almost always looks "attractively priced" on that basis. The reality is that the forward P/E multiple is now at 16.2x after bottoming at 11.7x at the market lows. The multiple has not been this high since February 2005 when the economic expansion was already nearly four-years old! Today's stock market, on this basis, is now being priced as if we are late in the cycle -- forget this mid-cycle valuation stuff.
At the October 2007 market highs, the forward P/E multiple was 15x compared to 16.2x today, so you can understand why it is that:
1. We think investors are paying too high a price to participate, and;
2. We think that valuations are closer to levels more befitting an economy in its more mature stages of expansion than in its infancy.
Valuation may not be the best timing device, but it still pays to know whether you are getting into the market at acceptable prices. If the S&P 500 was in a 700-750 range, de facto pricing in zero to 1% GDP growth, we would certainly be interested in boosting our allocations towards equities. But at 1,070 and over 4% GDP growth effectively being discounted, we will be spectators as opposed to participants, understanding that the key to success is to NOT buy at the peaks. So the strategy is to sit on the sidelines, be selective in our equity choices, and wait for the correction to come or for the fundamentals to catch up with this overvalued, overbought, overextended market. Remember, the reason why the tortoise won the race was because the hare got tired.
S&P 500 Is Way Ahead Of Itself
What do we know from 60 years of historical data? We know that the market typically faces serious valuation constraints once it breaches the 25x P/E multiple threshold. The average total return a year out for the S&P 500 is -0.3% and the median is -6.2%. The total return is negative a year later 60% of the time, so when we say that there is too much growth and too much risk embedded in the equity market right now, we like to think that we have history on our side.
There is much more in the article so it's well worth a look.
This rally has the same look and feel as the 1930 DOW rally. Is there more left? No one knows. What we do know is that on average it does not pay to play for it.
Moreover, forward earning's estimates are ridiculously high and loan loss reserves on commercial real estate, credit cards, walk-aways, foreclosures, etc. are grossly inadequate.
Assets At Banks Where ALLL Exceeds Nonperforming Loans
ALLL stands for allowances for loan and lease losses.
Allowances for loan losses will decrease as charge offs increase. However, the above charts are in relation to non-performing loans.
Because allowances for loan losses are a direct hit to earnings, and because allowances are at ridiculously low levels, bank earnings have been wildly over-stated. That is one indication of optimistic forward earnings.
Another indication of optimistic forward earnings is that banks have not yet gone to a mark-to-market model on assets. Factor both together and financial earning's estimates are wildly optimist.
Kroger, Walmart, Costco Blame Deflation For Poor Earnings
In regards to non-financials, bear in mind that Kroger, Walmart, Costco are blaming deflation for a drop in earnings. Please see Deflation Threat? What Deflation Threat? for an analysis.
Certainly that is an indication that forward estimates are too high. Moreover, with unemployment rate close to 10% and expected to rise for another 12-18 months, in light of the fact that consumer spending is 70% of the economy, bulls are extremely hard pressed to state where this miraculous growth in earnings will come from.
The only possible answer, and one typically only presented by the gold bulls and hyperinflationists is a complete collapse of the US dollar. While possible, I doubt it at this time.
For more on the US dollar vs. the Yuan, please see Competitive Currency Debasement - A Look at Rampant Monetary Expansion In China.
For more on global imbalances and the US dollar vs. other currencies please see Gold And The Watched Pot Theory.
Greater Fools' Game In Progress
What this all boils down to is the overly-optimistic crowd is playing the Greater Fools' Game once again. Some players realize it. Most don't. One thing is for certain, not everyone can leave the Greater Fool's Train at the same time once it starts heading in reverse.