In light of the recent volatility in the stock markets, this
article is offered as an update and addendum to the article:
Stock Market Should Be Renamed "
The Stock Auction
which we offered on May 12, 2010. There are important and
undeniable realities that we are discussing. Stock price charts, no
matter what length of time plotted, hours, days, weeks, months,
years or even decades, are always very jagged lines. In other
words, stock prices do not move in a smooth and consistent
On the other hand, fundamentals like earnings and cash flows
tend to draw a much less erratic line or picture. One reason why,
is that fundamentals are typically only reported four times a year,
or quarterly, whichever comes first. Joking aside, ultimately in
the long run fundamentals matter more than volatile price action
regarding the true value of a stock, portfolio or index.
Figure 1 below is an updated price correlated to earnings EDMP,
Inc. F.A.S.T. Graph for the S&P 500 since our previous article
on May 12, 2010. The green line with white triangles is a plotting
of S&P 500 operating earnings per share since 1996 multiplied
by 15, the average PE for the S&P 500 for the past 80 years.
The average growth rate of earnings since 1996 for the S&P 500
has been 5.2%. The blue line with asterisks depicts the 20-year
normal PE ratio of 17.5 for the S&P 500 over the past 20 years.
Note that it's only due to the infamous irrational exuberant period
form 1996-2000 that skewed the normal PE above the longer term
normal 15 multiple.
Also note that the operating earnings estimate for 2010 has
increased to $81.62 from the previous estimate of $78.36. If you
apply the normal 15 PE to the $81.62 earnings estimate you get a
2010 ending fair value of 1224. At 17.5 times earnings of $81.62,
the fair value number is 1428 for the S&P 500. That represents
range of 14% to 33% upside from the May 20, 2010 close of 1071.59.
There is no time on the graph where the S&P 500's price has
fallen materially below the 80-year normal PE ratio of 15. Also at
a 16.1 blended PE, the S&P 500 is close to its normal fair
value based on earnings
(Click charts to enlarge)
Figure 1: S&P 500 15yr EPS Growth Correlated to Price
The Store Where You Buy Stocks
Imagine that you were going shopping at your local Wal-Mart (
) store. As you drove into the parking lot you noticed it was full
of cars. Then as you entered the store, the isles were full of
shoppers with loaded shopping carts.
Suddenly, the store manager's voice comes over the PA system
with the following announcement: "Ladies and gentlemen, for being
such loyal Wal-Mart customers we are going to reward you. For the
next hour, all merchandise in the store is going on sale at 10%
off. Thank you for shopping Wal-Mart."
Then inexplicably, all the customers abandon their loaded carts
and flood out of the store. Then the store manager, coming to his
senses, turns on the loudspeakers in the parking lot and announces:
"Ladies and gentlemen, we apologize for our mistake. If you will
return to the store, all merchandise will be offered at 10% higher
prices than before you left."
At this point, all the customers hastily re-park their cars and
re-enter the store. Then they begin ripping merchandise off the
shelves at a much more feverish pace than they previously had. All
was now good in Wal-Mart land.
Obviously, sane Wal-Mart shoppers would never behave in such an
irrational way. When perfectly good merchandise went on sale, they
would become more motivated buyers. The stock market is the only
market on earth where shoppers flee the store when the merchandise
goes on sale.
Volatility Is Not Risk
In the investing world, much is written about volatility. Many
even consider volatility to be synonymous with risk. In our view,
the risk is not the volatility; rather it's the reaction to
volatility where true risk resides. If I am not planning to buy or
sell today, then today's volatility does not, or at least should
not, concern me. I know that in the long run operating performance
is what matters most. I am better served focusing on how the
businesses I own are performing. The metaphor above is in our view
more than a clever story. Behavioral psychologists have recently
pointed out that investors feel the pain of loss, two-and-a-half
times greater than they do the pleasure of gain.
Over short periods of time, fear and/or greed will dominate the
trading behavior of investors in financial markets. Emotion really
doesn't belong in investment analysis. However, the emotion "fear"
is the most dangerous of the two. In either case, when emotion
rules, investors tend to behave in an opposite manner, as to the
way they should behave.
The great advantage of the EDMP, Inc. F.A.S.T. Graphs is that
they illuminate the importance of valuation as it relates to
earnings. In the long run earnings determine market price. In the
short run, the two can become temporarily disconnected, however,
inevitably price will return to its earnings justified level.
Therefore, when trying to determine the future value or movement of
a stock or a market, it's wise to measure valuation relative to
earnings. Again, at the end of the day, this is what matters
A point of logic supporting this principle is the notion that
it's easier to forecast, within a reasonable degree of accuracy,
the prospects of a business than it is the short-term movement of
an often emotionally charged crowd called "The Market". Emotional
reactions are very unpredictable and subject to wide swings, in
markets this is known as volatility. On the other hand,
fundamentals change very little over short periods. Therefore,
focusing on the zigzagging price ball takes your eye off of the
critical intrinsic value ball where it belongs.
Be Greedy When Others Are Fearful
The legendary Warren Buffett has offered investors many gems of
wisdom over the years. Two of my favorites that apply to this
writing are: 1. "
Be greedy when others are fearful, and be fearful when others
", and 2. "
Fear is the foe of the faddist, but the friend of the
." The moral of these gems is to keep emotion in check when making
Figure 2 below re-visits Figure 1 above, with emphasis added for
clarity. The red shaded area highlights how overvalued stocks
became during the irrational exuberant period. Recognize that the
green earnings line with the white triangles represents the normal
PE of 15 for the S&P 500, and is where true worth valuation
resides. Therefore, this was a clear and evident time to be fearful
as others were greedy. Stock values had no rational place to go
except down at the greed peak of calendar year 2000.
The yellow shaded area depicts a time when fundamentals
(earnings) were collapsing. Here, stock prices followed earnings
down, and were behaving rationally based on fundamentals. Of
course, as we all remember, fear became quite manifest. The orange
arrow points to October of 2008 when Warren Buffett wrote his
Buy American. I Am.
", article for the New York Times. Yes, he was a little early, but
a good time to be greedy while others were fearful nevertheless.
Also, it's clear that price moves to where earnings are going, and
earnings are going up today.
Figure 2: S&P 500 15yr EPS Growth Correlated to Price
If we are to invest successfully, we need to place our attention
on what matters most and keep a level head. Years of research have
led us to conclude that earnings matter most and are the most
reliable predictor of future movements. Spend some time studying
Figure 1 or 2 and this point becomes self evident.
Standard & Poor's on their "
Earnings and Estimate Report
" dated May 19, 2010 make the following statement: "
With 97% of Q1 reported, earnings are posting a 12.5% positive
earnings surprise, with strong GAAP numbers; initial cash-flow
…" On this same report they estimate S&P 500 operating earnings
of $81.62, up 4.57% from their March 31, 2010 estimate of
Michael Santoli authored the Barron's Cover
Saturday, May 15, 2010, titled "
Stronger Than Ever
". The basic premise of this article is that Corporate America is
fiscally as fit as ever. Trends Magazine offered a multi-part
series in their April & May 2010 issues titled respectively "
A New Golden Age..
When people least expect it
" and "
Accelerating Innovation and the New Technology Boom
." These are just a few examples of encouraging information that
imply future business growth.
Our point is not to be Pollyanna. We don't covet that view any
more than we do the doom and gloom perspective. Instead, our
objective is to realistically evaluate the future based on the most
reliable prognostication tools available. If earnings do manifest
as forecast above, then future S&P 500 stock values will go
higher long term.
In our experience there is a preponderance of conclusive and
undeniable evidence which supports the functional relationship and
strong correlation between earnings and price. We believe in
keeping emotion out of the equation. Therefore, our focus is on
actual earnings as reported, coupled with reasonable forecasts
Neither hype nor hysteria is participated in here. The stock
market will surely experience bouts of volatility, but eventually
earnings will drive the direction and level of price action.
Therefore, we advise investors to watch their earnings closely and
always keep their perspectives rational.
No position in the S&P 500 index.
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.
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