How Overpriced Is the S&P?

Inquiring minds are wondering: How overpriced is the S&P?

It's an excellent question, given that the bulls feel the market is headed much higher while the bears feel the opposite after a remarkable 50% rally.

Let's start off with a look at the financial sector where Allowances for Loan and Lease Losses (ALLL) have plunged even though non-performing loans soar.

To understand the importance of ALLL, inquiring minds are reading a description of Allowances for Loan & Lease Losses.
 

“Businesses try to predict, on an ongoing basis, the amount of loss in their accounts. They take periodic charges to earnings to better match losses to periods when they occurred. Banks do this as well. They use current income, through the provision for loan and lease losses, to create and build a reserve to absorb losses.

“The ALLL can be increased another way. When the bank collects on previously charged-off loans, the amount recovered goes into the ALLL.

“Charged-off loans decrease the ALLL. If a bank decides it has overestimated its potential loss exposure, it can choose to reduce its ALLL and add the amount to its income. This is known as making “reverse provisions” for loan and lease losses, because the bank decreases the allowance, or reserve amount, rather than increasing the provision. It is rare for a bank to make a reverse provision, however, because of the imprecise nature of determining an appropriate reserve.

“One last point to remember with respect to the reserve is that the ALLL is a general reserve. Therefore, even if a bank analyzes and estimates the loss on each loan, the allowance is there to absorb all losses in the loan portfolio and is not specific to a particular loan.”

With that backdrop, let's take a look at a few charts.

Assets at banks whose ALLL exceeds Nonperforming Loans

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Banks with Total Assets from $1B to $10B where ALLL exceeds Nonperforming Loans

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Banks with Total Assets from $1B to $10B (Pacific Region) where ALLL exceeds nonperforming loans

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Banks with Total Assets over $20B where ALLL exceeds Nonperforming Loans

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Remember that allowances for loan losses will decrease as charge-offs increase. However, the above charts are in relation to non-performing loans.

Because allowances for loan losses are a direct hit to earnings, and because allowances are at ridiculously low levels, bank earnings have been wildly over-stated.