[copy] 3 Things – Forward Estimates, Valuations vs. Returns, Told You So
["3 Things" is a weekly publication of ideas, usually contrarian, to provoke thoughtful discussions and decision-making processes. As a portfolio strategist, I am sharing things that I am considering with respect to current investment models and portfolio allocations. Please feel free to email or tweet me with your comments and ideas.]
The Problem With Forward Estimates
I got into a debate recently with a gentleman who was adamant that current valuation levels in the market did not suggest trouble ahead. The problem is that his valuation argument was based on the use of forward operating earnings estimates. Let me explain why this is a faulty assumption.
The argument that forward earnings expectations are a good indicator of future returns in the market is not actually the case. The reason is that using forward earnings to estimate future returns is equivalent to "moving the target to the arrow."
If the studies kept the very first estimate of forward earnings as the measurement metric, the prediction accuracy would be substantially different. As shown below, estimates start out extremely optimistic and are continually adjusted downward to reality.
The suggestion that forward earnings estimate are a predictor of stock market returns is not quite accurate. In reality, the analysis uses TRAILING forward estimates, post the repeated adjustments, to claim success in predicting future returns. In other words, "the arrow was moved to the target." Viola.
This is why using "reported" earnings is the only accurate way to measure market valuations for two reasons. First, it is a based on "trailing reported earnings" that are final and devoid of future adjustments. They are also stripped of some of the "fudges" used to boost operating earnings which are quite substantial. To wit:
"Two business professors, Ilia Dichev and Shiva Rajgopal at Emory and Duke, conducted a survey of 169 chief financial officers at publicly-traded companies in the U.S. revealed at least 20 percent of the publicly-traded companies that, as required by law, report earnings results on a quarterly basis are probably fudging the numbers. Furthermore, almost every single CFO surveyed agreed that this is the case.
Their study found 'CFOs estimate that in any given period, roughly 20% of firms misrepresent their economic performance by managing earnings.' Further more "For such firms, the typical misrepresentation is about 10% of reported EPS."
The reasoning behind the fudging of earnings reflects the growing problems of stock based compensation practices. 'A large majority of CFOs feel that earnings misrepresentation occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives.'"
Secondly, all historical measures of valuation are based on trailing reported earnings. Therefore, using overly inflated forward earnings estimates to compare to trailing reported earnings is an "apples to oranges" comparison.
Trailing Valuations And Forward 5-Year Returns
With the above in mind, let's take a look at a historical study of valuations (based on trailing reported earnings.) I have compared those valuations to forward rolling 5-year real returns of the S&P 500 index to get a sense of what should be expected in the future.
(For the purposes of this article I am using Dr. Robert Shiller's CAPE valuation measure which is a 10-year average of monthly P/E's based on trailing reported earnings.)
There are TWO very important points to make in reference to this analysis:
1) Forward market returns are a function of the expansion and contraction of trailing valuations. At any given point, it is when valuations begin to contract that returns from the market over the next 5-years have also contracted and vice-versa.
2) When valuations have exceeded 23X trailing earnings, it has marked both the peak of valuation expansions and the beginning of poor forward returns as the overvaluation was corrected.
What is important to understand in this valuation debate is that the current level of valuation in the financial markets is extreme and suggest lower annualized returns in the future. HOWEVER, it is when valuations begin to CONTRACT that signals real trouble for investors in the not so distant future.
At 27.75 times earnings, based on the latest price/earnings data, the markets are now trading at the second highest valuation level in history. Given the ongoing deterioration in earnings, combined with market exuberance, valuations are still expanding. That is for now. However, it should be noted that forward rolling 5-year returns have already begun to decline, and it is likely only a function of time before valuations begin to contract as economic realities collide with Central Bank driven fantasies.
The Fed Suggests They Likely Won't Raise Interest Rates
In January this year I penned a post entitled "The Fed Might Not Raise Rates This Year" based on a very simple premise:
"While the consensus of economists expect GDP to accelerate in the months ahead, there are many data points (oil, copper, lumber, shipping rates, etc.) that suggest real economic activity is actually slowing down. The current trend and level of interest rates confirm the same as money continues to seek safety over risk."
During the past 25 years, there has never been a period when the Fed has initiated a tightening cycle with inflation below its 2% target as it is currently. Furthermore, the decline in the breakeven inflation rates suggests that inflation will decline further in the months ahead which puts the Fed at risk of exacerbating economic weakness if they move forward with interest rate hikes.
It is my expectation, unless these deflationary trends reverse course in very short order, the Fed will likely post-pone raising interest rates until at least the end of the year if not potentially longer. However, the Fed understands clearly that we are closer to the next economic recession than not and that they can not be caught with rates at the "zero bound" when that occurs."
Not surprisingly, the recent release of the FOMC meeting minutes suggests that I was right. Via the New York Times:
"The Federal Reserve is not sounding like an institution that is ready to raise its benchmark interest rate in June.
Fed officials at their most recent policy-making meeting in January worried that economic growth remained fragile, and that raising rates prematurely could undermine recent gains, according to an official account released Wednesday.
The account also described greater concerns than the Fed had disclosed previously about the sluggish pace of inflation and the decline of inflation expectations among investors."
The real issue here is that economic weakness is likely much greater than headline statistics, and the vast majority of mainstream economists, actually suggest. Furthermore, as I have repeatedly stated in the past, the ability for the U.S. economy to withstand the global storm of deflation is vastly limited.
It will be interesting to see what the Federal Reserve does next.
Sorry. No data so far.