John Hussman: How to value the S&P 500 now

It is impossible to properly value the stock market based on a single year of earnings, regardless of whether one uses actual net earnings or projected operating earnings.

Writing each of these sentences only once is woefully inadequate. If I had my way, investors would have to write them over and over five days a week. Wall Street analysts would have to write them a hundred times a day, immediately upon arriving to work.

In recent weeks, I’ve seen “valuation” arguments that literally treat future estimated operating earnings as if they are a pure, immediately distributable dividend that will grow indefinitely without the need for capital investment, while sustaining current record profit margins forever. I’ve heard analysts say, with a straight face, that stocks are cheaper here than they were at the 2009 lows, because the ratio of the S&P 500 to the current forward operating earnings estimate is lower today than it was 16 months ago. I’ve seen analysts presume to “capitalize” earnings into some sort of market valuation by doing nothing more than dividing estimated operating earnings by corporate bond yields that are presently nearly indistinguishable from Treasury yields.

The primary question investors need to ask is whether these analysts have actually examined the historical record of these approaches – not just whether they have an anecdote about some extreme such as 2000 or 1987 – but whether they have done a robust, long-term evaluation. Unless a “valuation” methodology is accompanied by long-term, decade-by-decade evidence showing that the valuation method is actually correlated with realized, subsequent market returns (particularly over a horizon of say, 7-10 years), then you are not looking at the sound valuation work an investment professional. You are either looking at a random guess or a sales pitch.

Don’t get me wrong. There are many thoughtful, well-disciplined financial planners and asset managers – usually far away from Wall Street – who are excellent stewards of their customers’ investments. My difficulty is not with those professionals, but with the careless and inept reasoning that passes for analysis hour after hour on the financial news.

If you take away one thing from this week’s comment, it is that stocks are a claim to a long-term stream of cash flows that will actually be distributed to investors over time, and that this stream of cash flows cannot be estimated from a single year’s earnings number. The main reason for this is that profit margins vary from year-to-year over the business cycle, and tend to mean-revert over the long-term. Earnings (net and operating) tend to be depressed during periods of economic strain, but when they reflect compressed profit margins, they are strongly associated with above-average rates of subsequent growth over the following 7-10 years. In contrast, earnings that reflect elevated profit margins are strongly associated with poor rates of subsequent growth. When analysts take earnings figures at face value, and presume to “capitalize” them simply by dividing by interest rates, they demonstrate a Kindergartener’s grasp of securities valuation.

Case in point is the treatment of forward operating earnings. The first problem is that analysts tend to treat these as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business. Meanwhile, operating earnings often include a benefit from those very same “extraordinary” sources – provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses). Forward operating earnings take these hypothetical earnings to the next level, and are based on the year-ahead forecasts of Wall Street analysts.

As long-term readers of these comments know, I am terribly concerned about the increasingly careless use of operating earnings as a measure of stock valuation, because I have yet to see an operating earnings model that is not ignorant, devious, misleading, lacking in historical evidence, repeatedly catastrophic, or all of the above. Not least of these concerns is that the commonly quoted “norm” of 15 for the P/E ratio properly applies to the ratio of the S&P 500 to trailing 12-month net earnings, which are invariably much lower than forward operating earnings. Operating earnings are not even defined under Generally Accepted Accounting Principles (GAAP). They were spawned by Wall Street in the early 1980’s, so there is (conveniently) no long-term history for this measure, meaning that the valuation bubble between the late 1990’s and 2007 represents a significant chunk of the observable record.

Still, the increasingly common use of this earnings measure requires us to somehow deal with it constructively. As it turns out, the lack of history prior to 1980 is not particularly difficult to overcome. We can very accurately explain the relationship between forward operating earnings and standard earnings measures using variables that have been observable throughout history, and can form good estimates prior to 1980 on that basis (see August 20, 2007 Long Term Evidence on the Fed Model and Forward Operating P/E Ratios ).

It is then straightforward to calculate objects such as the Fed Model (the ratio of the forward operating earnings yield to 10-year Treasury yields), and to demonstrate that it has zero correlation with subsequent market returns.

The question then becomes – is there any way that forward operating earnings (FOE) can be employed as a useful measure of market valuation? The answer is actually yes.

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