Hussman: Stocks Are Not Cheap Based On Forward Operating Earnings

One of the great dangers of bank stimulus that makes its way into securities markets is that it distorts the apparent health of the economy. The high-level, crony-replete financial system with its ties to government is far removed from economic factors that affect typical citizens in the US economy. It’s well understood by now that the tax dollars given to banks for the purpose of restarting lending and goosing business activity has instead gone largely into asset markets to pump them up and improve bank balance sheets. Anybody doubting that will become a believer after attempting to get a loan.

When asset markets jump, their wealth effect can help earnings dramatically even in non-financial companies. We’ve seen that over the past five quarters or so as stimulus seemed only to stimulate earnings reports. Now, we have those on the books. Some analysts look at those and project them ahead, as if the conditions of the stimulus will be sustained far into the future. That’s a sketchy assumption, though, considering that real economic numbers such as consumer confidence, retail sales, housing data, and other sets show that any stimulation achieved is already fading.

Another problem with projecting stimulus boosts into the future is that they can make current stock prices look cheap when they are not. They essentially are saying, “If the fake growth created by stimulus over the past year continues into future years even though the stimulus will be gone, stock prices are cheap today.” Couching the statement in official terms masks its absurdity.

John Hussman touched on this in his weekly comment yesterday, titled “Don’t Take the Bait,” from which the following:

I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require US profit margins to sustain levels about 50% above their historical norms indefinitely. Forward operating earnings are Wall Street’s estimates of next year’s earnings, omitting a whole range of actual charges such as loan losses, bad investments, restructuring charges, and the like.

The ratio of forward operating earnings to S&P 500 revenues is now higher than it has ever been. Based on historical data, the profit margin assumptions built into forward operating earnings are well beyond two standard deviations above the long-run norm. This is largely because, as Bill Hester noted in his research article last week, forward operating earnings are heavily determined by extrapolating the most recent year-over-year growth rate for earnings. In the current instance, this is likely to overshoot reality, and in any event, has little to do with the long-term cash flows that investors can actually expect to receive over time.

I can’t emphasize enough that when you hear an analyst say “stocks are cheap based on forward operating earnings” it would be best to replace that phrase in your head with “stocks are cheap based on Wall Street’s extrapolative estimates of a misleading number.”

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