Hussman Weekly Market Comment: Valuing the S&P 500 Using Forward Operating Earnings

It is impossible to properly estimate long-term cash flows based on a single year of earnings, regardless of whether one uses actual net earnings or projected operating earnings.

It is impossible to properly value the stock market based on a single year of earnings, regardless of whether one uses actual net earnings or projected operating earnings.

Writing each of these sentences only once is woefully inadequate. If I had my way, investors would have to write them over and over five days a week. Wall Street analysts would have to write them a hundred times a day, immediately upon arriving to work.

In recent weeks, I've seen "valuation" arguments that literally treat future estimated operating earnings as if they are a pure, immediately distributable dividend that will grow indefinitely without the need for capital investment, while sustaining current record profit margins forever. I've heard analysts say, with a straight face, that stocks are cheaper here than they were at the 2009 lows, because the ratio of the S&P 500 to the current forward operating earnings estimate is lower today than it was 16 months ago. I've seen analysts presume to "capitalize" earnings into some sort of market valuation by doing nothing more than dividing estimated operating earnings by corporate bond yields that are presently nearly indistinguishable from Treasury yields.

The primary question investors need to ask is whether these analysts have actually examined the historical record of these approaches - not just whether they have an anecdote about some extreme such as 2000 or 1987 - but whether they have done a robust, long-term evaluation. Unless a "valuation" methodology is accompanied by long-term, decade-by-decade evidence showing that the valuation method is actually correlated with realized, subsequent market returns (particularly over a horizon of say, 7-10 years), then you are not looking at the sound valuation work an investment professional. You are either looking at a random guess or a sales pitch.

Don't get me wrong. There are many thoughtful, well-disciplined financial planners and asset managers - usually far away from Wall Street - who are excellent stewards of their customers' investments. My difficulty is not with those professionals, but with the careless and inept reasoning that passes for analysis hour after hour on the financial news.

If you take away one thing from this week's comment, it is that stocks are a claim to a long-term stream of cash flows that will actually be distributed to investors over time, and that this stream of cash flows cannot be estimated from a single year's earnings number. The main reason for this is that profit margins vary from year-to-year over the business cycle, and tend to mean-revert over the long-term. Earnings (net and operating) tend to be depressed during periods of economic strain, but when they reflect compressed profit margins, they are strongly associated with above-average rates of subsequent growth over the following 7-10 years. In contrast, earnings that reflect elevated profit margins are strongly associated with poor rates of subsequent growth. When analysts take earnings figures at face value, and presume to "capitalize" them simply by dividing by interest rates, they demonstrate a Kindergartener's grasp of securities valuation.