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FRED
09-21-06, 11:42 AM
North American Equities: over- or under-valued? (pdf) (http://info.nbfinancial.com/fbn/files/fbnfbnpdf/en/2/w20060915_e.pdf)
September 15, 2006 (National Bank Financial Economy and Strategy Group)

Investors tend to attach a great deal of importance to price/earnings ratios in their calculations of whether markets are over or under-valued. However, these valuations are only useful if analysts’ projections are realistic.

The problem is that analysts tend to be overoptimistic at the end of long growth cycles and in periods prior to economic slowdowns. Given that our economic scenario is based on a significant slowdown in the United States (which should lead to a marked drop in profits throughout North America), there is a real risk that current forward PE ratios may well be over-optimistic. During strong economic slowdowns, profit growth tends to return to trend levels. By recalculating forward P/E levels using trend profit growth levels (as opposed to analysts’ consensus estimates), North American equities markets no longer appear undervalued.

AntiSpin: To find US stock market analysis that doesn't require AntiSpin, we find ourselves reaching out to our northern neighbor. A daily news item previously noted a Toronto Dominion Bank Economics analysis that explains how the housing-driven economic slowdown in the US may impact the Canadian economy. The analysis holds lessons for other economies as well.

This report by Pierre Lapointe and Jean-Christophe Daigneault of Canada's National Bank Financial Economy and Strategy Group is a solid examination of the track record of US equity analyst projections versus outcomes over a long period of time. Seems that analysts are just as prone to optimism at cycle tops as are stock buyers. In fact, analysts' optimism at the end of cycles appears predictable and measurable. Right now, their optimism is yet another signal that a correction in the near term is likely.

Not only do analysts tend to be optimistic, the Fed's stock pricing model–that didn't work so well in 1999 either–does not appear to be giving an accurate reading now.


http://www.itulip.com/images/fedmodel.png

The Fed model indicates that the S&P is undervalued

http://www.itulip.com/images/downwardrevisions.png
The CNB's analysis says that the S&P is overvalued
and to expect downward revisions by analysts


Who is more likely to be right? We got our money on our Canadian friends.

(Portions of National Bank Financial Economy and Strategy Group report above reprinted with written permission from National Bank Financial)


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Uncle Jack
09-21-06, 12:24 PM
We’re at peak earnings and all that activity, wealth creation through the real estate bubble (oops, I said it again), home equity extraction for big screen televisions, etc. is slowing down. The Fed believes that the slowing economy will contain inflation. Okay, sure. It will also contain growth, and therefore growth of earnings. If earnings decrease, that is - the E in P/E drops, you’ll get to your 21 multiple alright, but not via price appreciation.

Over-valued!

jk
09-21-06, 01:22 PM
i recommend that those not familiar with john hussman's writings on this topic visit his web site http://www.hussmanfunds.com . there you will find pieces showing that the so-called "fed model" is worthless, and that using normalized p/es, in which price is compared to peak earning, the market is over-valued. [hussman's approach is not too different conceptually from shiller's use of 10 year average earning.] hussman also has written on the record high earnings currently reported, and the implication that this means poor performance ahead.

akrowne
09-21-06, 02:08 PM
Eric:

The situation is in fact <b>even worse</b> than analysts simply being overly-optimistic: <b>profits themselves have a habit of mysteriously vanishing right before a recession (in hindsight)</b>, as assets that were assumed to be there are later found out not to be (through fraud, too-low risk allotments, or "structural optimism" in valuing accounts, etc.)

Here you get to see how corporate profits were about 20% over-estimated immediately prior to the 2001 recession:

http://br.endernet.org/~akrowne/econ/charts/corp_profits-before_and_after.gif

(courtesy of econbrowser)

Economists will still, with a straight face (and despite the data) claim that this does not happen--because why would a corporation lie <i>upwards</i> on its tax returns? But this is irrelevant--if profits are believed to be higher than otherwise, the company becomes worth more in the market. This translates directly into stock price and executive option grants. Paradox solved.

Uncle Jack
09-21-06, 06:54 PM
RE: JK's recommendation to check out Hussman is a good one.

Also as an excellent supplement is Ed Easterling's book, Unexpected Returns: Understanding Secular Stock Market Cycles.

The point that Hussman makes over and over again, and Easterling makes in his book, is that earnings of the S&P companies can only grow faster than GDP for a limited time, and then they hit a peak along a very long-term trend line. We're at that peak now. Over the long-term, the best you can hope for from a point of peak earnings is to grow no faster than nominal GDP, or 6-7%.

As is usually the case when you're at peak earnings, rarely do you just assume the 6-7% path, most likely the next move is down or sideways. Anyone paying up for stocks now just aren't going to get the long-run returns they are "expecting." It just won't happen.

Those expectations by the cheerleaders will most likely only be adjusted after companies start to disappoint, and after the downtrend has already established itself. It'll be a shame, again.
<img src="http://www.itulip.com/forums/images/icons/icon10.gif" />

Christoph von Gamm
09-22-06, 03:11 AM
RE: JK's recommendation to check out Hussman is a good one.
As is usually the case when you're at peak earnings, rarely do you just assume the 6-7% path, most likely the next move is down or sideways. Anyone paying up for stocks now just aren't going to get the long-run returns they are "expecting." It just won't happen.

Those expectations by the cheerleaders will most likely only be adjusted after companies start to disappoint, and after the downtrend has already established itself. It'll be a shame, again.
<img src="http://www.itulip.com/forums/images/icons/icon10.gif" />

We should not forget to mention several facts:
1. Real US GDP is lower than it is currently announced, we are at rather a 1% real GDP curve since a while. The rest is inflation.
2. The DJIA is a subselection of better performing global companies, and if one fails the DJIA will be reshuffled to reflect a better index picture. That means it is always biased towards success, but not towards the real picture of an ecomony. Similar goes with the S&P 500, but less obvious. But even here the index content shufflers have done a great deal of work to bring the "right" companies into scene. Most obvious it is with the Nasdaq where six years ago manx companies did exist that aren't there any more (Pets.com, worldcom, etc.)...
3. If the big companies are hit by economic downturn, usually the first thing they do is cut spending and pressure more suppliers by - a) prolongating the accounts payable ad infinitum - ever experienced how it feels not getting paid for 180 days??? whilst having outlays every month... b) agressively asking for christmas discounts on the total volume spent. As a result, the lower cap companies, often into B2B and therefore suppliers to the larger caps suffer even more from profit hits, which means that mid- and smallcaps are much more prone failure in downturns.

So if you want to preserve capital you should look after companies who have a steady revenue franchise from various sources which cannot be skipped that quickly by their clients, i.e. longterm outsourcing projects, software monthly payments, maintenance fees or highly proprietary equipment... that's amongst others the Utility sector might stay interesting... everything that is near a "CONSUMER" means Joe Sixpack is rather likely be affected by any upcoming consumer-induced downturn.

Does that make you crazy?

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Jim Nickerson
09-22-06, 09:45 AM
Chris v G makes interesting point about the periodic substitutions of the indices.

Does anyone know what stocks have been taken out of the Dow since its 2000 high?

I guess everyone knows about Shadow Government Statistics. I do not subscribe, but look periodically at its free charts, one of which already shows negative GDP http://www.shadowstats.com/cgi-bin/sgs/data for some quarters now.