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Generational Dynamics Web Log for 6-May-2008
Price/earnings ratios continue to surge on lower corporate earnings

Web Log - May, 2008

Price/earnings ratios continue to surge on lower corporate earnings

The dramatic trend that began last month gathers strength.

In a story that's becoming increasingly familiar, airheaded investors are pushing up stock prices despite falling corporate earnings. The reason appears to be the conviction, despite mountains of evidence to the contrary, that the credit crisis is over and the credit bubble is returning.

The result is that investors, who had been holding price/earnings ratios fairly constant for four years, have suddenly pushed them sharply upward. It's an amazing development.

Here's last Friday's version of the graph that appears on the bottom of this web site's home page:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 2-May-2008. <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 2-May-2008. (Source: MarketGauge ® by DataView, LLC)

After years of keeping the price/earnings ratio constant at 18, the ratio has been shooting up each week for the last 3 weeks, and has now reached 22. (May 18 - Correction)

Now, in these bubblehead days, that doesn't seem so high, but the historic average is around 14, and the index has been well above average since the dot-com bubble began in 1995. By the Law of Mean Reversion, the index is going to fall to about 5 for a number of years, once the credit bubble fully bursts. Instead, the index is rising again, meaning that the fall is going to be even worse. Icarus is flying closer and closer to the sun.

The reason that the price/earnings index is rising is because corporate earnings estimates keep falling. Each week I post the table of corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters. Here's the latest version:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%
  Mar 28:              -9.3%
  Apr  4:             -12.2%
  Apr 11:             -14.1%
  Apr 18:             -14.6%
  Apr 25:             -14.1%
  May  2:             -15.0%

I said last week not to be surprised if the first quarter earnings estimates start falling again, and they seem to be doing so, though not far. Still, the fall in earnings estimates, combined with last week's increase in stock prices, has pushed up price/earnings ratios to the highest value since 2004, a truly remarkable development.

The last few days, the euphoria among investors has been palpable.

Investors experienced a big gush of endorphins on Friday, when the monthly unemployment report revealed that the economy had lost "only" 20,000 jobs in April, when economists had predicted a lost of 80,000 jobs.

Another factor, the Microsoft/Yahoo merger, was highly euphoric to investors, because it appeared to signal a return to the time when the credit bubble was being boosted by merger and acquisition (M&A) activity. The collapse of that merger over the weekend certainly must have depressed investors, perhaps explaining Monday's selloff.

A lot of the euphoria is based on the widespread belief the financial crisis is over. This view was buttressed by Thursday's report from the Bank of England, even though the conclusion is contradicted by the bank's own data.

I'm not the only one who's noticed this insanity. A commentary by credit derivatives expert Satyajit Das contains the following chart that shows how market data is interpreted by today's analysts:

  Market            Analyst Call
  ------            ------------------------
  Weak data         Fed eases, stocks rally.
  Strong data       Strong economy, stocks rally.
  Consensus data    Lower volatility, stocks rally.
  Bank loses
      $8 billion    Bad news all out of the way, stocks rally.
  Oil price up      Good for energy producers, stocks rally.
  Oil price down    Good for consumers, stocks rally.
  US dollar down    Good for exporters, stocks rally.
  US dollar up      Lower inflation, stocks rally.
  Inflation up      Good for commodities and asset prices, stocks rally.
  Inflation down    Fed eases, stocks rally.
  Climate change    Soft commodities up, stocks rally.
  World ends        Good for disaster recovery companies, stocks rally.

According to Das, most analysts seem to share Eleanor Roosevelt’s view that: "The future belongs to those who believe in the beauty of their dreams."

Incidentally, I've written about Satyajit Das's views before, in an article posted last October.

What really surprises and shocks me is that Warren Buffett has joined the kool-aid crowd.

"The worst of the crisis in Wall Street is over," said Warren Buffett to CNBC and to Bloomberg.

This is a big change since 2006, when he said:

"Speculators are like Cinderella at the ball having a great time, but at midnight everything turns to pumpkins and mice. As midnight approaches the party gets to be more fun, and everyone thinks they'll get out before midnight. The problem for Cinderella is that there are no clocks on the wall."

It's an even bigger change than Buffett's attitude in 2003, when Buffett said that stocks were significantly overpriced -- with the Dow Industrials index at 8,000!

Even more startling was Friday's announcement that first quarter profits of Warren Buffett's Berkshire Hathaway fell by 64% because of $2 billion in losses from investments in derivative contracts.

This is the person who called derivatives "financial weapons of mass destruction." It was only a year ago, in May 2007, when he said this:

"The introduction of derivatives has totally made any regulation of margin requirements a joke. I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but ... at some point some very unpleasant things will happen in markets."

Even worse, according to one commentator, Buffett invested in derivatives "in one of the most simplistic and historically dangerous, indeed devastating, ways."

And so, Warren Buffett used to have a lot of common sense. I don't know how to interpret these recent announcements except to wonder if Buffett has completely lost his mind.

Here's a little black humor.

You may recall that in August of last year, depositers mobbed Countrywide Bank in California to withdraw their deposits, in the face of rumors of bankruptcy. Countrywide Bank was owned by Countrywide Financial Corp., the biggest home-loan company in the nation. Countrywide had practiced the most dangerous and simplistic mortgage lending practices, and was in serious trouble.

In January, in a move that I called "throwing good money after bad," Bank of America announced that it would acquire Countrywide.

Well now Bank of America appears to be changing its mind, at least according to some rumors. According to one analyst, "Countrywide's loan portfolio has deteriorated so rapidly that Countrywide currently has negative equity and the acquisition will be a drag on Bank of America's earnings."

Did you get the words "negative equity"? That means that Countrywide is now worth less than nothing. Theoretically, the stockholders should PAY YOU to take it off their hands.

How could Countrywide be worth less than nothing? Well, we can figure out what happened. Countrywide's standard practice was to offer 100% loans to home buyers, and now the vast majority of those homes are losing value. Therefore, the loan-to-value (LTV) ratios are now greater than 100%.

In other words, it you put together all the homes in Countrywide's entire loan portfolio into a big pile, then the total value of all those homes is smaller than the amount of money that Countrywide borrowed in order to make all those 100% loans. Putting it all together, Countrywide is worth less than nothing.

Martin Feldstein, president of the National Bureau of Economic Research <font face=Arial size=-2>(Source: CNBC)</font>

Martin Feldstein, president of the National Bureau of Economic Research (Source: CNBC)

On Tuesday morning CNBC interviewed Martin Feldstein, president of the National Bureau of Economic Research, who said the following:

"I'll tell you what worries me. We saw house prices overshoot by 60% relative to costs of building and relative to rents. I worry about the possibilty that they will keep falling, that they will spiral downwards, in the same way that they went much too high, they could go much too low. And if that happens, then we're going to see individuals feeling a lot poorer, cutting back on their spending, defaulting on mortgages, and we're going to see the holders of those mortgages see those assets, their capital being cut, and therefore their ability to make loans being cut."

In other words, Feldstein is predicting a panic, causing housing prices to fall much farther than they would have if there had never been a housing bubble. In fact, that's exactly what the data says is going to happen, as I said a week ago in "Home prices fall by the most on record."

But then Feldstein went on to say that regulators should prevent this from happening:

"So I think that there is a role to prevent this kind of downward overshooting in house prices. Prices have to fall somewhat from where they are today. But I think the danger is we have so many loan to value ratios greater than 100%, and those individuals are going to have a very strong temptation to simply turn in the keys and walk away. Because there's nobody to negotiate with. These mortgages have been securitized to a point where they cannot simply sit across the table from their mortgage originator from their bank and work it out."

I can't imagine why Feldstein believes that any regulator could possibly stop this downward spiral. As far as I know, no regulator has ever been able to stop a panic.

And so, putting all this together, we have giddy investors pushing price/earnings ratios up at a time when the news keeps getting worse. These are truly interesting times.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (6-May-2008) Permanent Link
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Generational Dynamics Web Log for 6-May-2008 Price/earnings ratios continue to surge on lower corporate earnings

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Generational Dynamics Web Log for 6-May-2008
Price/earnings ratios continue to surge on lower corporate earnings