Contributing editor Tom Slee is with us this week with an analysis of where the markets stand after a long upward run, followed by the big Monday retreat. Tom was a professional money manager for many years and is an expert in taxation matters. Over to him.
Tom Slee writes:
Now that the dust has settled and we can put the market collapse into perspective, one big question remains. What happened to the analysts? After all, they are paid to predict the future, to provide warnings. So where were they when we needed them last year? Even a heads-up would have been useful. Not a chance! Their forecasts were a disaster!
According to Bloomberg, Wall Street analysts kicked off 2008 by predicting an average 22% increase in bank and insurance companies' earnings. That was not only hopelessly wrong; many of the firms they were covering actually disappeared. To give you an example, Merrill Lynch's Guy Moszkowski, ranked the top analyst at the time, issued a buy recommendation on Lehman Brothers as late as June before downgrading to "no longer in business" three months later. That must be some sort of record!
Since then the analysts have been doing a little better, but not much. Estimates for the first quarter of 2009 were all over the place but the consensus was that U.S. profits would plunge 23% year-over-year. In fact, it now looks as though S&P 500 profits were down 35% compared to the first quarter in 2008. Canadian estimates were also far too optimistic. For instance, as recently as April UBS was forecasting a 24% decline in first-quarter TSX earnings. The decline was actually 36%, following on the heels of a 43% collapse in the fourth quarter of 2008.
In fairness, these are extraordinary times and analysts are in unchartered territory. Even so, I think that we could have expected more guidance, which is putting it kindly. Some money managers are disgusted. Graham Summers, senior market strategist at Omni Sans, thinks that the forecasting has been "abysmal" and believes that we should do away with analysts' projections altogether. I share his frustration, but where would that leave us? Given the market's spring recovery we need to get a handle on the outlook for 2009 and 2010 earnings in order to see whether stocks are still cheap or fully priced.
So are analysts an endangered species or can we depend on their projections now that we seem to be in calmer waters? Personally, I think that after the wake-up call their numbers are likely to be more reliable. Here's why. It so happens that in July the National Association of Securities Dealers' five-year constraint on analysts expires. You may recall that sprung from the high-tech conflict of interest cases. Because of the scandals, large brokerage firms were compelled to buy independent research for their clients and provide a comparison with their own recommendations; a sort of second opinion. The requirement is now coming to an end.
As a result, in order to see whether further supervision is needed, several studies of Wall Street earnings forecasts have recently been conducted. The encouraging thing is that the results showed analysts were increasingly accurate before the market collapse. It seems that they were doing their homework before being blindsided. Hopefully, they are now getting down to cases again.
Incidentally, I thought that you might be interested to know that the same studies showed analysts are still highly reluctant to issue sell recommendations. Prof. Brad M. Barber at the University of California found that buy recommendations fell by as much as one-third after brokers started to provide clients with independent research. When it came to selling, though, analysts choked up and resorted to buzz words. These days you have to know the code when reading a report. For the record, "hold", "accumulate", "long term buy", "market perform", and "market weight" can all mean "dump this as soon as possible". Anything sounding like faint praise is a warning signal. That said, let me reassure you that here at the IWB our recommendations mean exactly what they say and we have no compunction in saying "sell".
The next question is whether, in view of a struggling economy, the market is now running ahead of itself. In early March, when stocks were at 12-year lows, you could be confident that barring another disaster they were at least cheap. Now it's no longer certain that prices are supported by corporate earnings. As one commentator asked: is the market going to be a victim of its own success?
The numbers are sending mixed signals. Assuming that we can depend on analysts' forecasts and putting aside the never-ending arguments about what constitutes true earnings, here is the score. As I write, the S&P/TSX 60 Index is at 630, which is 17.5 times a consensus earnings estimate of about $36 this year and 12.9 times the $49 consensus for 2010. To put that in perspective, over the years money managers have regarded the market as relatively cheap at 14 times earnings and probably fully priced at 18 times. There is no sophisticated basis for those guidelines. I have, however, found them extremely useful.
In the U.S., the stock market surge since March has been extraordinary and investors are even more concerned about whether the advance is sustainable. According to Ned Davis Research of Florida, the price earnings multiple of the S&P 500 has jumped 40% since early March. Their study shows that average P/E multiples have tended to climb about 10% during the first three months of recoveries since 1929. Obviously, U.S. investors are banking on a snap-back in the economy and a rebound in corporate profits. On the other hand, American markets still seem reasonably priced, certainly vis-Ã -vis the TSX.
Based on normal earnings estimates, the S&P 500 has a P/E in the 22 range. However, given the serious reservations people have about some of the forecasts it has been suggested that a median P/E makes more sense. In other words, it would be better to use a mid-point between the different S&P 500 estimates. That way the unusually high and low numbers are cushioned. Based on this technique, P/E of the S&P 500 is currently at an acceptable 15.6.
To summarize, the markets have rebounded very quickly but are still not overpriced. Of course, there are going to be corrections and some profit taking after the recent surge. That would happen even if we were in a prolonged healthy bull market. However, based on the numbers, I think that any set-back is likely to be short-lived and we could see a further advance if there are no more surprises and third and fourth-quarter earnings meet expectations.
Sure, there has been an unusually strong surge but remember that we came off one of the most severe market crashes in history. Now the recovery, probably spasmodic, is underway. I would be cautiously adding to top-quality blue-chip positions.
Tom Slee writes:
Now that the dust has settled and we can put the market collapse into perspective, one big question remains. What happened to the analysts? After all, they are paid to predict the future, to provide warnings. So where were they when we needed them last year? Even a heads-up would have been useful. Not a chance! Their forecasts were a disaster!
According to Bloomberg, Wall Street analysts kicked off 2008 by predicting an average 22% increase in bank and insurance companies' earnings. That was not only hopelessly wrong; many of the firms they were covering actually disappeared. To give you an example, Merrill Lynch's Guy Moszkowski, ranked the top analyst at the time, issued a buy recommendation on Lehman Brothers as late as June before downgrading to "no longer in business" three months later. That must be some sort of record!
Since then the analysts have been doing a little better, but not much. Estimates for the first quarter of 2009 were all over the place but the consensus was that U.S. profits would plunge 23% year-over-year. In fact, it now looks as though S&P 500 profits were down 35% compared to the first quarter in 2008. Canadian estimates were also far too optimistic. For instance, as recently as April UBS was forecasting a 24% decline in first-quarter TSX earnings. The decline was actually 36%, following on the heels of a 43% collapse in the fourth quarter of 2008.
In fairness, these are extraordinary times and analysts are in unchartered territory. Even so, I think that we could have expected more guidance, which is putting it kindly. Some money managers are disgusted. Graham Summers, senior market strategist at Omni Sans, thinks that the forecasting has been "abysmal" and believes that we should do away with analysts' projections altogether. I share his frustration, but where would that leave us? Given the market's spring recovery we need to get a handle on the outlook for 2009 and 2010 earnings in order to see whether stocks are still cheap or fully priced.
So are analysts an endangered species or can we depend on their projections now that we seem to be in calmer waters? Personally, I think that after the wake-up call their numbers are likely to be more reliable. Here's why. It so happens that in July the National Association of Securities Dealers' five-year constraint on analysts expires. You may recall that sprung from the high-tech conflict of interest cases. Because of the scandals, large brokerage firms were compelled to buy independent research for their clients and provide a comparison with their own recommendations; a sort of second opinion. The requirement is now coming to an end.
As a result, in order to see whether further supervision is needed, several studies of Wall Street earnings forecasts have recently been conducted. The encouraging thing is that the results showed analysts were increasingly accurate before the market collapse. It seems that they were doing their homework before being blindsided. Hopefully, they are now getting down to cases again.
Incidentally, I thought that you might be interested to know that the same studies showed analysts are still highly reluctant to issue sell recommendations. Prof. Brad M. Barber at the University of California found that buy recommendations fell by as much as one-third after brokers started to provide clients with independent research. When it came to selling, though, analysts choked up and resorted to buzz words. These days you have to know the code when reading a report. For the record, "hold", "accumulate", "long term buy", "market perform", and "market weight" can all mean "dump this as soon as possible". Anything sounding like faint praise is a warning signal. That said, let me reassure you that here at the IWB our recommendations mean exactly what they say and we have no compunction in saying "sell".
The next question is whether, in view of a struggling economy, the market is now running ahead of itself. In early March, when stocks were at 12-year lows, you could be confident that barring another disaster they were at least cheap. Now it's no longer certain that prices are supported by corporate earnings. As one commentator asked: is the market going to be a victim of its own success?
The numbers are sending mixed signals. Assuming that we can depend on analysts' forecasts and putting aside the never-ending arguments about what constitutes true earnings, here is the score. As I write, the S&P/TSX 60 Index is at 630, which is 17.5 times a consensus earnings estimate of about $36 this year and 12.9 times the $49 consensus for 2010. To put that in perspective, over the years money managers have regarded the market as relatively cheap at 14 times earnings and probably fully priced at 18 times. There is no sophisticated basis for those guidelines. I have, however, found them extremely useful.
In the U.S., the stock market surge since March has been extraordinary and investors are even more concerned about whether the advance is sustainable. According to Ned Davis Research of Florida, the price earnings multiple of the S&P 500 has jumped 40% since early March. Their study shows that average P/E multiples have tended to climb about 10% during the first three months of recoveries since 1929. Obviously, U.S. investors are banking on a snap-back in the economy and a rebound in corporate profits. On the other hand, American markets still seem reasonably priced, certainly vis-Ã -vis the TSX.
Based on normal earnings estimates, the S&P 500 has a P/E in the 22 range. However, given the serious reservations people have about some of the forecasts it has been suggested that a median P/E makes more sense. In other words, it would be better to use a mid-point between the different S&P 500 estimates. That way the unusually high and low numbers are cushioned. Based on this technique, P/E of the S&P 500 is currently at an acceptable 15.6.
To summarize, the markets have rebounded very quickly but are still not overpriced. Of course, there are going to be corrections and some profit taking after the recent surge. That would happen even if we were in a prolonged healthy bull market. However, based on the numbers, I think that any set-back is likely to be short-lived and we could see a further advance if there are no more surprises and third and fourth-quarter earnings meet expectations.
Sure, there has been an unusually strong surge but remember that we came off one of the most severe market crashes in history. Now the recovery, probably spasmodic, is underway. I would be cautiously adding to top-quality blue-chip positions.
