"Valuations are also a problem. While we continue to hear that the market is "cheap on forward operating earnings", analysts who worship at the altar of forward operating earnings seem to overlook two factors, in my view. First, profit margins are more than 50% above historical norms, and profits to GDP are nearly 70% above historical norms. .........
This leads to the second factor that analysts seem to ignore Specifically, major market downturns are not driven by a simple downturn in earnings over a year or two, but instead invariably reflect a change in the valuation of the entire long-term stream of cash flows (either because expected long-term cash flows are revised, or because investors require greater long-term prospective returns). We often hear analysts talk as if the change in the S&P 500 should simply track the change in earnings
over the same period. But the historical correlation between the two - for example, the year-over-year change in earnings versus the year-over-year change in the S&P 500 - is close to zero. Major stock price fluctuations nearly always reflect a shift in expected long-term cash flows or in required long-term prospective returns.
To illustrate this, suppose you have a company that is expected to earn $2 per share next year, pays half of earnings out as
dividends, and grows at 5% annually each year, ad infinitum. In order to expect a 10% return from this stock over the long-term, you would pay $20 a share today (essentially giving you 5% from expected price growth and 5% from dividend yield). In order to expect a 6% return on this stock, you would pay $100 [5% growth + 1% yield: P = D/(k-g)]. Now let's wipe out all of the
earnings and dividends in the coming year, but leave the long-term flows unchanged. If you do the math, you'll find that in each case, the value of the stock drops by only about 90 cents. The only way you'll get a huge change in the price of the stock is if you've misjudged the whole stream of long-term cash flows (which is what I believe analysts are doing by failing to adjust for profit margins and using a single year of earnings as the whole basis for valuation), or if you change the long-term prospective return that the stock is priced to achieve. "
This leads to the second factor that analysts seem to ignore Specifically, major market downturns are not driven by a simple downturn in earnings over a year or two, but instead invariably reflect a change in the valuation of the entire long-term stream of cash flows (either because expected long-term cash flows are revised, or because investors require greater long-term prospective returns). We often hear analysts talk as if the change in the S&P 500 should simply track the change in earnings
over the same period. But the historical correlation between the two - for example, the year-over-year change in earnings versus the year-over-year change in the S&P 500 - is close to zero. Major stock price fluctuations nearly always reflect a shift in expected long-term cash flows or in required long-term prospective returns.
To illustrate this, suppose you have a company that is expected to earn $2 per share next year, pays half of earnings out as
dividends, and grows at 5% annually each year, ad infinitum. In order to expect a 10% return from this stock over the long-term, you would pay $20 a share today (essentially giving you 5% from expected price growth and 5% from dividend yield). In order to expect a 6% return on this stock, you would pay $100 [5% growth + 1% yield: P = D/(k-g)]. Now let's wipe out all of the
earnings and dividends in the coming year, but leave the long-term flows unchanged. If you do the math, you'll find that in each case, the value of the stock drops by only about 90 cents. The only way you'll get a huge change in the price of the stock is if you've misjudged the whole stream of long-term cash flows (which is what I believe analysts are doing by failing to adjust for profit margins and using a single year of earnings as the whole basis for valuation), or if you change the long-term prospective return that the stock is priced to achieve. "
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