Stock Market’s Current P/E Valuation a Fallacy

Stock Market’s Current P/E ValuationSome believe the stock market is trading at a low price/earnings (P/E) multiple, meaning stocks are historically cheap.

The P/E multiple takes the current market price per share of a company or index and divides it by the corporate earnings per share of that company/index.

Historically, P/E multiples between 0 and 10 are considered undervalued, indicating a good time to invest. When the range is 10-17, the companies/indices are considered fair value; 18-25 is overvalued; with anything above 25 considered a bubble (the S&P 500 was way above 25 during the tech bubble).

The one-year forward-looking P/E multiple for the S&P 500 is currently 12.75, which is clearly fairly valued, but bordering on the undervalued. (Source: Wall Street Journal, June 18, 2012.)


That may be so, but that means the “E” or corporate earnings part of the P/E equation must grow in a global economy that is slowing.

I’ve written in these pages about how corporations, once the financial crisis hit, reduced the number of employees that they had (their costs), which helped support corporate earnings and the stock market.

Now that American corporations have cut expenses to the bone, the only way corporate earnings can grow is if revenue grows. This is evidenced by U.S. productivity numbers: they continued to grow in 2009-2011 as corporations cut staff and so produced more with less—they were more productive. This translated into higher U.S. productivity numbers and higher corporate earnings.

But, in 2012, U.S. productivity has gone negative. This means corporations have reached their limit to how operationally efficient they can be (they can’t cut expenses more without affecting their capability to operate). In order to increase corporate earnings, revenue growth is going to have to take the lead.

In the first quarter of 2012, S&P 500 companies experienced revenue growth of 6.5% (source: Wall Street Journal, June 18, 2012). Comparatively, in 2010 and 2011, the S&P 500 companies experienced 10.7% revenue growth.

Not only is revenue growth slowing, but also the 12-month forward estimate for revenue growth for the S&P 500 companies is only 4.7%!

In 2010 and 2011, Asia—led by China and India—helped the rest of the world grow. In 2012, Asian economies are slowing down dramatically. I believe estimates for 4.7% revenue growth for U.S. corporations over the next 12 months are optimistic, which threatens corporate earnings.

If U.S. corporations are as lean as can be and revenue growth is struggling with the global economic slowdown, then how will corporate earnings grow to sustain a P/E multiple of 12.75? The answer is that they won’t.

Without another round of quantitative easing (QE), also known as money printing, the S&P 500 is extremely vulnerable to further downside, as evidenced by the lack of corporate earnings growth…another reason why I believe some form of QE will be most likely launched.

Michael’s Personal Notes:

Once again, investors are excited about the fact that the National Association of Home Builders/Wells Fargo Housing Market Index is at its highest level since 2007 (source: MarketWatch, June 18, 2012).

The major issue that is not mentioned concerning the housing market index is the fact that there was a mortgage settlement last month that will alter the U.S. housing market in the coming years.

As we all know, after the financial crisis, there was a lawsuit against the big banks for mortgage fraud. This prevented the banks from foreclosing on homes because of the lawsuit.

Now that the lawsuit is settled, foreclosures and renegotiations with homeowners on the part of the banks can begin.

The $25.0-billion settlement with the banks took place in April. In May, foreclosures increased by 9.1% from April’s level in the housing market. This was the first increase in two years (source: RealtyTrac). Coincidence?

These new foreclosed properties slowly making their way onto the housing market will result in greater housing inventory and will drag down home prices. If May is any indication of how the rest of 2012 will go, and since this is just the beginning of the number of foreclosures that will come onto the market from the settlement, then home prices are going to have real trouble rising in this environment.

There are other troubling statistics that will ensure continued pressure on home prices and on the housing market in general, splashing cold water on the idea that a recovery in the housing market is imminent.

There are over 2.8 million homeowners behind more than a year on their mortgages (source: The Big Picture, June 18, 2012). As is obvious to the dear reader, homeowners who are this far behind with their mortgages usually never catch up. Their homes either go up for auction or go into foreclosure, or the homeowner eventually just walks away. This will add to inventory in the housing market and prevent home prices from rising.

An alarming one in five homeowners has been more than 90 days delinquent on their mortgage since 2007. These people cannot qualify for a new mortgage at a lower rate because of their poor credit score. These homeowners will continue to just get by, if they can. Others will simply default or walk away, as mentioned. This backdrop does not make for a healthy housing market and is not conducive to higher home prices, because more homes will be up for sale.

Where the Market Stands; Where it’s Headed:

We are near the end of a bear market rally in stocks that started in March of 2009. In fact, if it were not for the market’s belief we will have another round of quantitative easing, stock prices would be sharply lower today.

Economies worldwide are slowing quickly. This will put pressure on corporate profits and, in due course, move the stock market lower. No amount of money printing can help a stock market if the companies that are part of that market do not see demand for their products and services grow. As I have written above in today’s lead story, revenue growth is eluding corporate America.

What He Said:

“The Dow Jones Industrial Average, the S&P 500 and the other major stock market indices finished yesterday with the best two-day showing since 2002. I’m looking at the market rally of the past two days as a classic stock market bear trap. As the economy gets closer to contraction, 2008 will likely be a most challenging economic year for America.” Michael Lombardi in Profit Confidential, November 29, 2007. The Dow Jones Industrial peaked at 14,279 in October 2007. A “sucker’s rally” developed in November 2007, which Michael quickly classified as bear trap for his readers. By mid-November 2008, the Dow Jones Industrial Average was at 8,726.