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Has the Market Become Untradable?

It's time to rethink valuation metrics

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An Oct. 31 Bloomberg article said “More than 10,000 estimates suggest the S&P will advance to 1,447.93. Analyst forecasts imply the benchmark measure will post its biggest rally since the 1990s technology bubble, when the gain since March 2009 is included.”

Wow, that’s a pretty big statement. Analyst estimates are largely based on earnings-based valuations. “The last four quarters EPS total of $94.80 (for S&P 500) exceeds the previous peak of $91.47 achieved in second quarter 2007,” according to Goldman Sachs.

You are probably tempted to re-read this statement, but it’s true: Earnings just came in at an all-time high; stocks didn’t. What does this mean and what’s the chance of the S&P rallying to 1,447.93?

Don’t Ignore Analyst Estimates

It’s no secret that I don’t have much respect for Wall Street analysts and their analysis, but that doesn’t mean you have to ignore them — use them as contrarian indicators. Here are some popular 2011 forecasts given in December 2010:

  • Dec. 16, 2010 — USA TODAY: “Experts agree. Get over your fear and get back into stocks.”
    Dec. 18, 2010 — Barrons 2011 Outlook: “Our group of investment experts sees stocks continuing their climb next year as the economic recovery takes hold.”
    Dec. 29, 2010 — Seattle Times: “Economic rebound forecast for 2011.”

Looking at the same valuations analysts used, the December issue of the 2010 ETF Profit Strategy Newsletter simply stated that: “Over the long-term, stocks are priced to deliver pain, not gain.”

Record earnings in 2007 spelled trouble for the market and record projected earnings for 2011 foreshadowed trouble for the market.

Are Valuations out of Date?

The fact that corporate profits in 2011 trumped the previous 2007 all-time high boggles my mind. According to Standard & Poor’s, the P/E ratio (based on reported earnings) is at 14.48 (as of 9/30/2011) and projected to drop below 13 in 2012. Merely judging by the P/E ratio, stocks are as cheap today as they were in 1989, the last time S&P had a P/E ratio below 15. Does that make sense?

It doesn’t, but here’s what’s driven earnings:

  1. Corporations have “fired” their way to record profits by firing hundreds of thousands of workers. While this has caused a short-term profit spike, it has eroded their customer base.
  2. The “E” (earnings) of P/E has never been more manipulated. New accounting rules have allowed banks and financials to post profits even as toxic assets continue to erode their financial stability.

Unlike earnings (and the P/E ratio), dividend yields can’t be manipulated. Either a company pays dividends or it doesn’t. Dividend yields are near an all-time low. The S&P 500 pays a meager 1.96%, the Dow Jones 2.68% and the Nasdaq 0.78%.

Even the iShares Dow Jones Select Dividend (ETF) (NYSE:DVY) has a yield of only 3.54%. Vanguard Value ETF (NYSE:VTV) pays only 2.60%. One bad day on Wall Street (and we’ve had many of those) can wipe out an entire year’s worth of dividends.

Low dividend yields are commonly seen at market tops and directly contradict the upbeat message of low P/E levels. In fact, dividend yields are within striking distance of their 2007 level and not much higher than in 2000. Which indicator would you rather trust, one that can be manipulated or one that can’t?

Is the Market Untradable?

The good news is you don’t have to trade to make money. In fact, you don’t even have to be invested to make money.

Article printed from InvestorPlace Media,

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