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Bubble in Earnings, Stocks, Or Both?


The bubble in stocks is a direct result of a bubble in earnings.


I have to admit that lately I am not in the most bullish of moods about stocks in general. The debate rages on as to whether stocks are cheap or if they are not. I suppose if you really believe the earnings are of high quality and that dividends would magically increase, then stocks appear to be only modestly overvalued on an historical basis.

But therein lies the problem. Today, myself and several colleagues (like John Succo) have been back and forth regarding the quality of earnings earlier. My take generally is that earnings have magically increased as a result of profit margins increasing due to productivity gains, reflation, outsourcing of jobs and restructuring efforts. And, oh yes, stock buybacks increasingly supported by increased debt.

My suspicion is that any major setback in the market will happen when the crowd finally realizes that the true underlying P/E of the market will rise as the stimulus is removed. There is only a finite number of buybacks, restructuring, etc. that a company or an economy can do. When that limit is reached, I believe that stocks will suffer a nasty spill as P/E's contract with earnings.

The key here is that the economy doesn't necessarily have to fall into a nasty recession for this to occur. It could be a market event that would eventually cause a negative wealth effect.
So the bubble in stocks is a direct result of a bubble in earnings. This is a direct result of shenanigans in the boardroom.

The question we must ask ourselves is what would you pay for the S&P 500 in an environment of falling earnings? Certainly not 18x current earnings. Maybe more along the lines of 10x earnings. That is a long way down from here.

One other subject I would like to cover is: what does it take for a secular low in stocks? Please see the chart below, courtesy of Ned Davis Research. The chart depicts data from the past century that suggests that markets bottom after 16 years of a zero return. Assuming the top was made in 2000, which would suggest a bottom around 9 years from now. It could happen faster, but we could just flop around in a huge trading range over the next decade. The top in 2000 serves as the poster child for a bubble.

This potential bubble is what gives my firm pause about the market and makes us a little more of a trader than we would like, but I feel that our returns in the future will be motivated and possibly generated by being aware of these valuable data points.

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No positions in stocks mentioned.

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