Sunday, 21 October 2007

Reserves, Profits and Multiples

One of the key problems with valuation in the stock market today is the difficulty of determining actual profits are trying to compare the numbers that are reported to previous years where different standards were used. Many bulls have tried to tell me that I should buy because the S&P 500 is selling at a P/E of only 16x 2008 earnings. Well, there are a ton of problems with that statement so let's just cover the fatal flaws.

First, I don't know what 2008 earnings are going to be and neither do they. They are using a guess as the denominator to get that multiple. The number we do have is the historical reported numbers and based on that the multiple is 18x, significantly higher.

Second, 18x is very expensive and even 16x is far from cheap. 16x would be a normal peak multiple over the business cycle. 18x would be extreme territory normally. During the 20th century, the P/E for the S&P 500 has exceeded 18x on a sustained basis 3 times: the late 1920s, the mid 1960s and the late 1990s. Each of them was followed by epic bear markets. Not a good set of precedents.

Each of those periods also featured prolonged (multi-year) periods of high earnings growth. We had the same thing this time in 2004-05 but EPS growth has fallen from 18% to 0% while equity indexes make new highs. Dangerous? You bet! In the past stocks rolled over shortly after earnings growth started to slow down. This time they refuse to roll over even when the slowdown is about to go to negative growth.

Then there is the quality of the profits themselves. The financial sector and banks in particular are quite problematic. The NY Times has done excellent coverage on the severe depletion of loss reserves at the big banks.

Some investors seem to think that banks’ current share prices reflect whatever grim earnings news remains ahead for the sector. But anyone who thinks that we have hit bottom in the increasingly scary lending world is paying little mind to the remarkably low levels of reserves that the big banks have set aside for loan losses. Indeed, loss provisions as a percentage of total loans held for investment plummeted to a historic low in the second quarter of 2007, the most recent period for which comprehensive figures are available.

Yep, we're heading into a major default crisis and banks have the lowest reserves ever. That's not a problem or anything that the Fed and Treasury want us to worry about. But the weak reserves have allowed financials to over-report profits for the last several years. Time to correct that and the price will be weak profits and for some, losses instead for the forseeable future. And I'm supposed to be interested in paying extreme peak multiples for inflated financial sector profits? No thanks.

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