Equities Not “Cheap”: Hussman

A constant refrain from many Wall Street analysts these days is that stock share prices are at “generational lows” based on forward operating earnings.  Generally these analysts have looked at price-earnings-ratios and surmised that if the current forward P/E on the S&P 500 is at roughly 12 and the historic average P/E is 18, then stocks are undervalued.  Not so, says fund manager John P. Hussman.

Hussman, in his most recent weekly market commentary, points out a fundamental flaw in the Wall Street reliance on forward earnings: how those expected earnings are calculated.  “Forward operating earnings are Wall Street’s estimates of next year’s earnings, omitting a whole range of actual charges such as loan losses, bad investments, restructuring charges, and the like. The ratio of forward operating earnings to S&P 500 revenues is now higher than it has ever been,” Hussman writes.  The reason: “forward operating earnings are heavily determined by extrapolating the most recent year-over-year growth rate for earnings.”  That is tantamount to using a single data point as evidence that a trend has begun.

For example, in the current environment, using Wall Street’s analysis, one would argue that a one-month uptick in housing prices means that housing prices will only go higher in ensuing months at the same or higher rate.  However, as anyone who has taken basic math can attest, one data point does not a trend make—even two or three data points are not really good enough to establish a reliable trend.

Hussman points out, too, “operating earnings” are not defined in the Generally Accepted Accounting Principles (GAAP) that corporations must use in preparing financial statements.  Thus, Wall Street can define that term any way it wants.  But, it is net earnings that should matter to investors, because only the actual cash left over after all expenses have been paid is what may be returned to investors in the form of dividends or invested in the company’s future.

On that issue, Hussman notes, “Still, net earnings represent the only amounts that investors can hope to obtain, and then only if the net earnings are distributed as dividends or invested in productive activities that don’t get written off later. It’s those net earnings that go into the calculation of [Robert] Shiller’s cyclically-adjusted P/E (CAPE), and the results are not kind here.”  According to the CAPE analysis, on June 10, 2010, the S&P 500 Index was overvalued by 50 percent.

Wall Street wants you to buy, but Hussman is likely right, “don’t take the bait.”

Read Hussman’s Weekly Market Comment by clicking here: Don’t Take The Bait.