stock price

Bloomberg has a story this morning which highlights the rapid growth in earnings of S&P 500 companies. The article notes that the price earnings ratio is now at only 14, which is below the five year average ratio of 16.4.

The article mentions that while the economic recovery has been sluggish, corporate earnings have jumped 9.6% over the past year. The article also states that companies which earn their profits domestically have been ‘unduly punished.’

We find this type of article (and headline) to be a great indicator of a market top. While it is impossible to predict what the stock market will do, as pundits become increasingly bullish investors should become increasingly cautious.

The article uses only the most common metric, the price earnings or (PE) ratio over the past twelve months (PE TTM). At ValueWalk we think that the PE TTM is a severly flawed metric. We like to use other metrics such as Shiller PE, which accounts for 10 years of earnings. The reason being that the last ten years of earnings cover an entire business cycle. PE TTM only indicates what the market has done the past twelve months.

Very often the past twelve months of earnings are not a good indicator of real sustainable earnings. The Federal Reserve has pledged to keep interest rates at close to zero until the end of 2014. This not only pushes investors into stocks, but also inflates corporate earnings due to low borrowing costs.

Furthermore, high earnings in one year can be a sign of a bubble. At the market top in 2007, according to most estimates the PE TTM was 15. Over the subsequent 15 months, the S&P500 fell by over 50%.

High earnings right now are in large part due to high margin levels. Profit margin levels are at a historic high of 12%. The numbers are inflated due to cost cutting which will likely be unsustainable in the future. When margin levels revert to their mean, earnings should fall 25-50%

As we mentioned, we like the Shiller PE to measure market valuations. The Shiller PE is at 22.5, which is 37% above its historic mean of 16.4. If profit margins and the Shiller PE reverted to their means, the stock market would be far from cheap.

We do not think a market crash is likely, nor are we predicting one. Furthermore, we have only looked at quantitative metrics and not even mentioned Europe, which we think the market is foolishly ignoring. However, investors should be careful of simple headlines which claim that now is a great time to buy stocks.