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John Hussman: Valuing the S&P 500 Using Forward Operating Earnings

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August 02, 2010 – Comments (8)

John Hussman of www.hussmanfunds.com puts out a Weekly Market Comment (which I highly encourage you to read every week). Per usual, this is another good article. This WMC discusses (obviously) a more rigorous approach to valuations and expected returns using FOE. Also there is a very important update on macroeconomic risks.

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Valuing the S&P 500 Using Forward Operating Earnings
Aug 2, 2010
John P. Hussman, Ph.D.

http://www.hussman.net/wmc/wmc100802.htm

[excerpt]

It is impossible to properly estimate long-term cash flows based on a single year of earnings, regardless of whether one uses actual net earnings or projected operating earnings.

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.

8 Comments – Post Your Own

#1) On August 02, 2010 at 1:39 PM, MegaEurope (21.53) wrote:

Awesome article.  Very fair and balanced, both bulls and bears need to read this.

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#2) On August 02, 2010 at 5:04 PM, binve (< 20) wrote:

MegaEurope ,

Thanks Mega. I competely agree. Hussman is one of the few economists that calls it like he sees it, without sugar coating. He also runs a hedge fund so he very much wants to see both sides of an argument. He is very methodical and statistically / historically based..

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#3) On August 02, 2010 at 10:08 PM, Tastylunch (29.32) wrote:

for once Megaeurope and I agree!

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#4) On August 02, 2010 at 11:41 PM, MegaEurope (21.53) wrote:

You might not agree with me, but I nearly always agree with you buddy.  :)

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#5) On August 05, 2010 at 4:48 PM, rhallbick (99.64) wrote:

Mr. Hussman's website is in my browser folder "Top Commentary", as I share your view of his work.  A little splash in the face with some longer-term reality helps keep me anchored.

I'm still giving thought to the commentary and charts relating to the various models that predict expected ten-year total S&P returns.  It first reminded me of some statements that Warren Buffet made about ten years ago.  He said something to the effect that he expected market returns to only be a couple of percent, annualized, over the next ten years.  This was at a time when many investors had begun to think that a twenty percent return was "normal"

I was also thinking that these same charts seemed to show a steady decline of the median expected market return for the last seventy years, from about 15 to 7.5.  I was speculating that the increased participation of the retail investor, with his mutual funds and 401k's, was slowing driving prices up and returns down.  I would love to see the same charts going back to 1900, to get a few more major recessions included.  There may not have been enough major cycles shown.

He said that he was surprised that the market popped back up such that the expected return was only about six percent, but I see that as better than a ten-year Treasury, so it makes some kind of sense to me.  All the same, I look to lighten up some on major rallies and buy when it really hits the fan.

 

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#6) On August 05, 2010 at 4:57 PM, goalie37 (91.92) wrote:

Earnings estimates always baffle me.  Every quarter we see earnings come in.  Sometimes they beat, sometimes they miss, and only once in a while do they meet expectations.  If analysts are so frequently wrong about the next three months, how can they predict the future farther out?

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#7) On August 05, 2010 at 11:19 PM, binve (< 20) wrote:

rhallbick ,

>>Mr. Hussman's website is in my browser folder "Top Commentary", as I share your view of his work.  A little splash in the face with some longer-term reality helps keep me anchored.

I totally agree! Excellent comments, thanks!

goalie37 ,

That is an *excellent* question :)..

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#8) On August 06, 2010 at 4:07 PM, Melaschasm (52.90) wrote:

Earnings estimates and long range forecasts. 

From a statistical standpoint, short term variations tend to become more pronounced over time.

For example:

If quarterly EPS estimates usually are within a nickel either way, it is reasonable to believe that yearly estimates would be within a quarter each direction.  From there we could estimate that a decade long earnings estimate should be within $5 either way.  Since we know that estimates are occasionally off by a massive amount on a quarterly report, we should expect a big variance to be more common on a yearly estimate, and over the course of a decade at least one big variance should be expected.

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