A few investment strategists have recently started to argue that stocks are significantly overvalued relative to “normalized” earnings. Their self-evident truth is that normalized earnings are lower than actual earnings so stocks are especially overpriced and vulnerable to a big fall from their current prices. These strategists have been the bull market’s perma-bears, who consistently underestimated the rebound in earnings since 2009.
Now these bears are saying that since the S&P 500’s operating profit margin is at a record high of 9.7% (based on the trailing four-quarter average), it must inevitably revert to its mean, which is 7.6% using data available since 1994. Normalizing S&P 500 forward earnings to this mean would reduce earnings by 22% and boost the normalized forward P/E to a bubbly 19.2, well above the conventionally measured current reading of 15.0. I think that’s their contention.
Since a cyclically high profit margin will always revert to its mean and fall below it during a recession, this normalization approach to valuation simply implies that stocks are overvalued relative to earnings if a recession is coming soon. Of course, since the perma-bears have been predicting an imminent “endgame” scenario since the start of the bull market, their latest spin is clearly just a variation on their bearish theme. What has changed is that they aren’t as strident about impending doom, so they’ve tactically switched to the notion that stocks are too expensive given that doom is inevitable, even if it isn’t imminent.
Today's Morning Briefing: Bully! (1) Are we all wild and crazy bulls now? (2) The bears have left the building. (3) A sell signal for contrarians? (4) P/E-led rally since summer 2011. (5) From depressed to normal valuation. (6) Bubble in angst. (7) More stocks are getting pricey. (8) Does it make sense to compare stock prices to “normalized” earnings? (9) Record high profit margin in Q3. (10) Approaching bubble territory. (11) Fundamentals remain mostly upbeat. (12) “The Hunger Games: Catching Fire” (-). (More for subscribers.)
Now these bears are saying that since the S&P 500’s operating profit margin is at a record high of 9.7% (based on the trailing four-quarter average), it must inevitably revert to its mean, which is 7.6% using data available since 1994. Normalizing S&P 500 forward earnings to this mean would reduce earnings by 22% and boost the normalized forward P/E to a bubbly 19.2, well above the conventionally measured current reading of 15.0. I think that’s their contention.
Since a cyclically high profit margin will always revert to its mean and fall below it during a recession, this normalization approach to valuation simply implies that stocks are overvalued relative to earnings if a recession is coming soon. Of course, since the perma-bears have been predicting an imminent “endgame” scenario since the start of the bull market, their latest spin is clearly just a variation on their bearish theme. What has changed is that they aren’t as strident about impending doom, so they’ve tactically switched to the notion that stocks are too expensive given that doom is inevitable, even if it isn’t imminent.
Today's Morning Briefing: Bully! (1) Are we all wild and crazy bulls now? (2) The bears have left the building. (3) A sell signal for contrarians? (4) P/E-led rally since summer 2011. (5) From depressed to normal valuation. (6) Bubble in angst. (7) More stocks are getting pricey. (8) Does it make sense to compare stock prices to “normalized” earnings? (9) Record high profit margin in Q3. (10) Approaching bubble territory. (11) Fundamentals remain mostly upbeat. (12) “The Hunger Games: Catching Fire” (-). (More for subscribers.)
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