Now, to the issue of P/E ratios based on forward operating earnings. As noted above, it's clear that forward operating earnings are generally much higher than the record level for trailing net earnings to-date, and of course, record earnings are always equal to or higher than raw trailing earnings.
Investors are used to the idea that “normal” P/E ratios are typically in the range of 14 to 16. But as Cliff Asness of AQR has repeatedly stressed, those norms are based on raw trailing earnings. If you calculate P/E ratios based on earnings figures that are higher, you clearly obtain lower P/E ratios.
As it happens, the long-term historical norm for the P/E ratio based on forward operating earnings would be about 12.
It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.
That assumption is hard to support. Historically, profit margins have been highly cyclical. But it's important to understand the argument here. I am not arguing that stocks are vulnerable because profit margins are going to come down, so earnings are going to come down, so stocks are going to follow earnings lower. No. There is virtually no correlation between year-over-year movements in earnings and year-over-year movements in stock prices. The argument isn't about the near term direction of earnings.
Rather, the argument is about the long-term valuation of stocks. If an investor is going to use the current level of earnings to determine the reasonable price to pay for a long-term asset, it had better be true that those earnings represent a normal and sustainable level of profit. You wouldn't buy a lemonade stand by extrapolating the profits it earns in August.
The following chart presents the ratio of forward operating earnings to S&P 500 revenues (net profit margins are even more volatile).
You'll notice that prior to 1995, there were only a few instances when operating profit margins exceeded 8%. At those points, prior to the late-1990's bubble, the forward operating P/E for the S&P 500 averaged just 8. That's not a typo.
Investors appear eager to “scoop up” so-called “bargains” on the belief that stocks are “cheap relative to bonds.” All of this is predicated on the belief that profit margins will remain at record highs, that the Fed Model is correct, and that P/E ratios based on extremely elevated measures of earnings should be evaluated based on norms for much more restrained measures of earnings.
That's not investing. It's speculation. And it's speculation that runs entirely counter to historical evidence. While an improvement in market internals might provide reason to speculate modestly on the basis of market action, there is no investment merit in current market valuations. Again, we do not need stocks to become “fairly valued” or undervalued in order to remove most or all of our hedges, but in the absence of reasonable valuation, we do need constructive market internals (short of extremely overbought or overbullish conditions).
Look at the composition of S&P 500 earnings. Financials currently make up about 25% of the S&P 500 market capitalization, but close to 40% of the earnings. Wages and salaries as a fraction of U.S. corporate profits have rarely been lower. Irresponsible lending and suppressed labor costs have been strong contributors to S&P 500 earnings in recent years thanks to a massive leveraging cycle – financial profits exploded, while wage demands stayed low because it was easy to spend out of home equity withdrawals and strong real-estate gains. But these are not permanent factors, and it is dangerous to value stocks as if recent profit margins will endure in perpetuity.
Based on daily closing prices, the S&P 500 has not even experienced a 10% correction, yet the recent decline has been characterized as if investors are acting “like the world is about to end.” This is not the pinnacle of human irrationality, but in fact, quite a shallow selloff from a historical standpoint. The fact that Wall Street is branding it otherwise is evidence that investors have completely forgotten how deep the market's losses can periodically become.