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Generational Dynamics Web Log for 15-Oct-2008
Corporate earnings continue to plummet

Web Log - October, 2008

Corporate earnings continue to plummet

Price/earnings ratio (P/E10 only) falls below average for first time in 13 years.

As regular readers know, for the last few quarters I've been posting the table of S&P 500 average corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters. These tables have shown sharp falls in corporate earnings estimates from week to week. Here's table as of the end of last week:


  Date    3Q Earnings growth estimate as of that date
  ------- -------------------------------------------
  Mar  3:              25.0%
  Apr  1:              17.3%   Start of previous (2nd) quarter
  Jul  1:              12.6%   Start of quarter
  Sep  5:               0.8%
  Sep 12:              -1.6%
  Sep 19:              -0.3%
  Sep 26:              -1.7%   End of quarter
  Oct  3:              -4.8%
  Oct 10:              -7.8%

We're seeing a very familiar pattern -- the same pattern that we've seen for the last four quarters. At the beginning, analysts expect meteoric increases in earnings growth. The earnings estimates fall as the quarter progresses. Once the quarter ends, and actual earnings begin to be published, the earnings estimates plummet.

A fall in earnings estimates means an increase of price/earnings ratios estimates.

There's a price/earnings ratio chart at the bottom of this web site's home page, and it gets updated automatically every Friday. Here's last Friday's version of the chart:


S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 10-Oct-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 10-Oct-2008. (Source: MarketGauge ® by DataView, LLC)

As you can see, the P/E ratio index was at 18 for several years, which is well above the historical average of 14. In fact, the index has been above average for 13 years, since 1995, and by the Law of Mean Reversion, this means it has to be equally below average for roughly the next 13 years.

Starting in March, however, the P/E index is spiked upward again, to astronomical levels in the 20s. This was when first quarter actual earnings were coming in. But investors believed that they should be ignored; the common wisdom was that the credit crisis would be over by the fall (i.e., now), and that earnings would grow in the third and fourth quarter by 25% and 50%, respectively.

Because of that widely held belief, investors pushed the P/E index up into the 20s. It's only in the last three weeks that it came back down to 18. This was thanks to the stock market losing 25% of its value in the last three weeks.

However, Monday's drunken orgy, pushing the stock market up 11%, has also pushed the P/E index up above 20 again. Those who claim to believe that the market is going to rally this quarter, in the face of falling corporate earnings and high P/E ratios, are going to be disappointed.

Market Summary

Asian and European markets were sharply higher last night. Wall Street opened sharply higher, with the Dow up 400 points at one time. But by 11 am, the Wall Street indexes turned around, and are now flat or negative.


Market summary, 14-Oct-2008
Market summary, 14-Oct-2008

The pundits, who this morning were still grinning like idiots, as if they'd just gotten laid, were talking about how and why everyone should get back into the market. By the end of the day, the pundits were far more serious, as the Dow fell to a 300 point loss, before partially recovering.

At the very least, what this means is that the panic buying spree that followed the latest worldwide insanity bailout is over, and stoned, drunken investors are beginning to sober up and look at the reality.

One sobering reality is that P/E indexes are still astronomically high, and computer software is telling investors to "Sell! Sell! Sell!"

Another sobering reality is that the market is still 35% down from its high, and there is still a lot of deleveraging and forced selling going on. In fact, investors are withdrawing money from money market funds at record levels, causing a potential chain reaction.

(Correction: A web site reader has pointed out the phrase "money market funds" is incorrect in the above paragraph. The record withdrawals are from stock and bond mutual funds, and those are not money market funds.)

Nouriel Roubini provided another sobering reality. In a Bloomberg interview, he said that the US would have the worst recession in 40 years. "There are significant downside risks still to the market and the economy," he said. "We're going to be surprised by the severity of the recession and the severity of the financial losses."

Nobel prize winning economist Paul Krugman spent the day texting Matt Damon. He did have a hard-hitting statement in his blog, however, saying that, "The policy outlook has improved a lot.... But itís way too soon to start counting chickens."

P/E10 drops below average for the first time since 1995

According to Robert Shiller, in a WSJ interview, the price/earnings index (P/E10) has fallen below average for the first time since 1995.

Robert Shiller, whose 1999 book "Irrational Exuberance" predicted the Nasdaq crash, and whose 2005 second edition predicted the real estate bubble crash, has a web site that provides the historical data that I and other researchers use.

When I write about the "price/earnings ratio" or P/E ratio, I'm usually referring to P/E1 -- the current price of a share of stock, divided by the company's earnings per share for the previous year. This is the version that's used in the chart that appears on the bottom of this web site's home page.

Robert Shiller prefers to use the measure P/E10 -- the current price of a share of stock, divided by the average of the company's earnings for the previous 10 years.

I believe that P/E10 is a more meaningful measure, but I write about P/E1 because it's easier for people to understand, and it makes the same point: That P/E ratios have been way above average since 1995, and by the Law of Mean Reversion, will have to fall to values way below average for roughly the next 13 years. Either P/E1 or P/E10 can be used, as long as it's used consistently. The historical average for P/E1 is about 14.1, and the historical average for P/E10 is about 16.3.

According to Robert Shiller, last week's bloodbath brought P/E10 down to 15, which is below the historic average of 16.3.

In the Wall Street Journal interview with Shiller, he says he "doesn't make predictions" and he's afraid that "it might go down a lot more." He's being very diplomatic with the Journal, by not quoting the Law of Mean Reversion, which says that it will certainly go down a lot farther, and stay down for a long time.

So add P/E10 to the list of things that have been crashing in the last weeks -- commodities, emerging market currencies, worldwide stock prices, the Baltic Dry Index, various major financial institutions -- and now add one more, P/E10.

This is a huge downward trend with a great deal of momentum. It's like a ten thousand-pound boulder is rolling downhill, and you'd like to stop the boulder, and start pushing it up the hill again. It can't be done.

(Comments: For reader comments, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (15-Oct-2008) Permanent Link
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