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Generational Dynamics Web Log for 18-Dec-07
As corporate earnings fall, stock prices rush to catch up

Web Log - December, 2007

As corporate earnings fall, stock prices rush to catch up

Price/earnings ratios have risen significantly in the last few weeks, as estimates for fourth quarter earnings have continued to fall.

The stock market bubble has been driven in recent years partially by investor anticipation of continued double-digit earnings growth. However, estimates have fallen sharply in the last half of this year.

At the beginning of Q3, estimates were that corporate earnings would grow by 6.2%; at the end, corporate earnings actually FELL 2.4%.

The fall appears to be accelerating in Q4, according to the latest summary from CNBC's earnings central:

"Earnings Central Stats As of Friday, December 14th:

4 companies in the S&P 500 have reported earnings for Q4, 75% have beaten estimates, 25% were in-line, and none have missed. (Data provided by Reuters Estimates)The blended earnings growth rate for the S&P 500 in fourth-quarter 2007, combining actual numbers for companies that have reported, and estimates for companies yet to report, fell to -3.8%, down from -1.3% last week, attributed in part to downward estimate revisions in Financials, including Bank of America, Washington Mutual and Citigroup.

At the start of the quarter, the growth rate for Q4 was 11.5%. (Data provided by Thomson Financial)"

In other words, the estimate at the beginning of Q4 was that earnings would grow by 11.5%; instead, the current estimate is that they FALL by 3.8%. That's even worse than last week's estimate, that they would fall by 1.3%.

The fall in corporate earnings growth is taking its toll on "stock valuations" or "stock price/earnings ratios." As the earnings fall, the P/E ratio goes up.

There's a price/earnings ratio chart at the bottom of this web site's home page, and it gets updated automatically every Friday. Here's the December 14 version of the chart:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 14-Dec-2007. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 14-Dec-2007. (Source: MarketGauge ® by DataView, LLC)

As you can see, the P/E ratio varied between 17 and 18 for the last year, but recently went up to about 19. This increase reflects the fall in earnings estimates.

This could explain why Wall Street stocks have been falling recently. Investors all tend to follow the same formula, based on something called the "Fed Model," a fallacious but widely used investment formula derived from a single paragraph buried deep in a 1997 Federal Reserve report. As P/E ratios rise, this formula will tell them that stocks are overpriced.

From the point of view of Generational Dynamics, the stock market is indeed overpriced -- by a factor of around 250% -- as I explained in my article "How to compute the 'real value' of the stock market."

Central banks - the US Federal Reserve (Fed), the Bank of England (BoE), the European Central Bank (ECB) -- have all been taking steps to increase liquidity, to fight the "credit crunch." Last week's spectacular announcement by world central banks of a plan to end credit crunch is being supplemented by various more informal plans to provide liquidity in various ways.

However, as I explained in "Questions and answers about the 'credit crunch,'" there isn't enough money in the world to fill the hole left by continually contracting amount of money in the world. The credit bubble is deflating, apparently with increasing speed. The central banks are desperately trying to pump it up again, but they can't keep up.

So far, it seems likely that stock prices have been controlled mostly by institutional investors; there aren't too many "Main Street" investors who have been reacted to the credit crunch so far.

But we're now overdue for a "generation panic and crash," an elemental force of nature that hasn't been seen since the 1929 crash. The generations of people who survived the 1929 crash and the horrors of the 1930s Great Depression are gone now. Today's leaders are Boomers and Generation-Xers who have never seen anything like a generational stock market panic and crash, and don't even believe that it's possible. At some point, millions or tens of millions of Boomers and Xers will panic and try to sell off their stocks, resulting in a new generational panic and crash, and it can't be stopped any more than a tsunami can be stopped. (18-Dec-07) Permanent Link
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Generational Dynamics Web Log for 18-Dec-07 As corporate earnings fall, stock prices rush to catch up

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Generational Dynamics Web Log for 18-Dec-07
As corporate earnings fall, stock prices rush to catch up