Bearish News

Below is a snapshot of CNBC from November 27, 1999. The Nasdaq closed at 3447 that Friday. We were still 3.5 months away from the March 10 peak of 5100, but remain 41% lower today.

Source: archive.org. You can go dig around Archive’s Wayback Machine, if you’re so inclined. Plug in an interesting URL and scan through archived pages. Share anything good with us.

There are countless tech-boom-era sites to explore. Imagine all the embarassing headlines to be cherry-picked. There might be a forgotten article titled “Dow to 350k” lurking out there, just waiting for long-due ridicule and scorn.

Current estimates of the S&P 500′s P/E are all over the place, ranging from 16 to 134. Which one is right? Depends on your perspective. Bulls almost always use “operating earnings” as the basis for their price/earnings calculations. This method excludes losses/charges seen as “non-recurring” or “one time”. Loan-writedowns, employee stock compensation, and many more items can be labeled as “non-recurring”, and thus excluded from OE.

The result is a subjective and optimistic version of true earnings. It’s kind of like saying, “I made a killing in Vegas this week*. (*excludes losses from blackjack, booze, and strippers)”.

Bears prefer to look at “reported earnings”, or those that adhere to GAAP (Generally Accepted Accounting Practices). We think it presents a more realistic picture of the bottom line. It’s certainly more objective, and has been the traditional way earnings are reported since the 1920s.  But in the ’90s, use of Pro-Forma accounting to create operating earnings skyrocketed.

This insightful infographic from The Chart Store speaks volumes on the issue. The bottom-chart shows “reported earnings”, and goes back to 1927. As you can see, the use of “operating earnings” has caused some inflated valuations, to say the least.

Mainstream media outlets typically highlight operating earnings. The problem arises when they say that stocks are “historically cheap”? By what measure? Operating earnings? Companies in the past didn’t exclude losses from their earning statements. So if you use an apples-apples means of measuring, equities are extremely expensive according to historic norms (reported earnings).

Please don’t trade on this data, or anything else I post here. As Keynes said, “The market can stay irrational longer than you can stay solvent”. I’m not a big fan of his, but that one was spot-on. For more info on earnings interpretation, read this Barrons piece from last year. It concluded that reported earnings (the more bearish of the two) is the more fair measure.

Edited and Updated for Clarity on 7/24/09.
No positions in any companies mentioned.

Bernanke’s WSJ editorial did little to assure his critics. He went to great lengths to explain the various tools they have for contracting the money supply. But for many skeptics, the issue is not if The Fed has the tools to tighten or not. It’s whether they’ll use them when the time comes. Putting on the brakes on the economy is a hard decision to make, and getting the timing right is near impossible. The Fed has been behind the curve for most of its history. No reason to expect a different outcome this time (how’s that saying go?).

Why should we believe that they’re going to yank the rug out from under the “recovery”? We shouldn’t. Reflating the bubble has been done many times now, and  nobody wants the bubble-cycle to end on their watch. It’s understandable, since the adjustment would probably be rather unpleasant. But at least we’d start the necessary process of rebuilding our financial system.

At this point, inflation, even if uncomfortably high, is almost surely viewed as by the Fed and politicians as preferrable to a major correction (though they won’t admit to it).

Now let’s hear from some people much more credible than me. Here are excerpts from Bill Fleckenstein and Mike Shedlock’s reactions to Bernanke’s editorial:

Bill Fleckenstein (subscription only, well-worth it though):

There’s no point in reprising the exit strategy, because when it comes to monetary policy, there is none. Effective and prudently conducted monetary policy is not about technique. It’s about having the vision or foresight about what to do; and then, more importantly, having the will to implement whatever the right policy is (usually to tighten credit or slow the growth of money). A group of men who can’t see a stock- and then a real-estate bubble building obviously don’t have any vision.

Bernanke’s verbiage was just a whole lot of hot air (though I did get a chuckle out of a Bloomberg headline that quoted him as urging “prompt attention” to reining in the budget deficit — a great example of the pot calling the kettle black). In any case, one will be sorely disappointed if they expect the Fed to ever pick the right path.

Mish explains what happens if they do tighten, and apparently thinks they will (good piece with details on the tools Bernanke plans to use):

However, when the Fed is forced to do so, the economy is likely to be smashed back into a second (or third) serious recession in a hurry. Indeed the recovery is going to be so weak in the interim, for most consumers it will feel as if the recession never ended.

The Fed micro-mismanaging interest rates and monetary policy is the primary reason we are in this mess in the first place. If we did not have a Fed, we would not need a Fed Exit Strategy!

Saying that equities are overvalued here is a monumental understatement. The market is priced for a miraculous recovery, in every sector, starting tomorrow. It’s priced as if America’s debt (at all levels) will disappear, or is a non-issue. Valuations must also assume that consumers will resume spending beyond their means immediately, and that this is sustainable.

None of these rosy scenarios are gonna happen. Consumer-spending hit a wall last Fall, when it finally dawned on people that we can’t spend forever, using inflated houses as refi-ATMS. Another, more severe collapse is imminent. But we might move up for a while longer, so be careful on the short side. This market is manipulated and delusional.

A Note on Price/Earnings Ratios

The 134x P/E is based on trailing 12 month P/E. This is the reported (or real) earnings. Many media outlets and companies prefer to focus on so-called pro-forma, or “operating earnings”. I did a follow-up piece here on that.

Updated 7/27/09