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The below article presents some data which should help you in looking at the stock market from a different perspective.  The goal is to assess the current valuation of the stock market when compared to the past.  To do this we are going to look at the following data:

• S&P 500 past EPS results

• S&P 500 EPS estimates for 2002 & beyond

• S&P 500 EPS warnings / surprises

• S&P 500 market valuations - past & present

• Drivers of economic growth

Data below indicates fewer revisions and warnings appear which is good.  This means that analysts are starting to sober up and revise their EPS estimates down.  I would note though that EPS growth rates, shown at the bottom, don’t appear impressive at all.

               3Q00     4Q00      1Q01    2Q01    3Q01    4Q01      1Q02    2Q02     Norm

Warnings       3.4      2.6        4.3       3.7       3.3        1.5       1.5       1.3         2.7

Revisions      -2.5   -11.3     -13.4    -11.0     -13.6     -13.4     -2.0      -2.6        -3.0

Surprise         3.2      0.9        3.8       1.7       0.9        1.0       3.0      4.0E*      2.8

Growth         18.4     3.5       -6.1     -17.0    -21.6     -21.5    -11.5      2.0E*      7.2  

Source: www.FirstCall.com

S&P 500 EPS results are shown near the bottom.  It appears as though EPS results aren’t declining at an astronomical rate anymore.  Nonetheless, growth rates aren’t stunning. 

The below tables state the S&P 500 EPS estimates for 2002 & 2003 based on different categories.  As you can see, industry analysts appear to have forecast close to a 20% increase in EPS results from 2002 to 2003.  The multiples assigned to 2003 results are only relevant if the companies attain their forecasted EPS results.

The PE ratio is one of the most widely watched measures of valuation for both the stock market as a whole and individual stocks. Many people use it to determine whether the market (or a given stock) is "expensive" or "cheap". The calculation is very simple. You simply divide the price by the yearly earnings. For instance, as of last week the S&P 500's closing price was 852.  The cumulative earnings for the 500 companies in the index are $51.46. So the PE ratio is calculated as 852 / 51.46 = 16.56. This means that if you are investing in the S&P 500 via a stock index fund, you are paying $16.56 for each dollar of earnings that those 500 companies will have this year.

The PE ratio does not work very well as a timing device, but it can give you some idea of the whether the market is "cheap" or "expensive". And as you can see from the below chart, it is definitely not cheap right now, even after the large losses that the market has suffered.

So how do the EPS multiples shown below compare to historic data?

Source: www.chartoftheday.com

Based on the excellent chart provided by www.chartoftheday.com it appears as though market multiples were quite high in June.  Remember, market lows are typically marked by pessimism in the stock market.  I personally sense a lot of fear and cynicism but too many investors are hooked on “buy and hold” so they continue to plow money into their 401k plans. 

Lets take a different look at market multiples vs. historic levels.

     Source: Lowrisk.com, FirstCall.com, BetterBizBooks.com

The above graph is quite illustrative. 

1. Valuations are starting to come down to reality.
2. Do you believe corporations can grow EPS by 20% to deserve the forecasted multiple of 13.9?
3. Valuation levels appear to be in line with the bottom seen in 1996. 
4. Valuation levels are still higher than those seen after the ’87 crash.

I believe the above chart fails to show investors one solid thing. 

I fail to see how corporations are going to generate 20% EPS growth rate next year.  Additionally, I doubt that the 500 companies in the index will be able to grow their EPS at 12% a year over the next five years (data provided by first call).  

Why do I believe these forecasts are too optimistic?

In order to generate the EPS growth rates forecasted next year corporations are going to have to generate TOP LINE GROWTH.  To date many corporations have reduced head counts, curtailed discretionary spending, cut capital costs & refinanced debt to increase or sustain earnings this year.  Where will the top line growth come from for the 500 companies in the index?  What will stimulate top line growth?

At the end of the day consumers, government and corporate America are going to have to rebuild their balance sheets in the next five years.  At best, if they don’t repair them, each group has very little incremental room to stimulate demand above and beyond what they can currently afford to spend (ie. They can’t afford to take on more debt to fuel growth.)

So what will drive the top line growth?

As I stated in my June 6,2002 comments. America is one nation under debt!

1. The government owes $5.6 trillion in debt.  This amount has grown at 8% per year for the last 23 years!  Every American owes tons of debt to the world, courtesy of Uncle Sam.  After all, 15% of every American’s payroll taxes now go towards paying interest on the national debt.  That isn’t productive capital at all.
2. Consumer debt levels are at record high levels vs. disposable income.  The data below from the Federal Reserve illustrates this.

Concluding comments:  I believe stock valuations, following the recent market meltdown in June and July, are starting to appear cheaper on a historical basis.  At the same time, record low interest rates are helping to sustain stock market multiples due poor returns from alternative investment opportunities.  Using the so-called "Fed model" some analysts are making a case that equities are undervalued at today's levels.  Nonetheless, even though valuations appear cheap they aren't at levels experienced in most recessions.  I believe that multiples will be reduced in the next few months as foreign capital flees the United States due to (1) a weakening currency (2) poor investment returns (3) weak EPS growth and (4) concern about continued budget deficits.  

I am VERY concerned about FUTURE EPS GROWTH.  EPS growth stems primarily from top line growth.  At the end of the day the United States has experienced 20 years of bubble like spending by the U.S. government, corporate America and the consumer.  Through taking on incremental amounts of debt during the last 20 years demand has caused asset prices (homes and stocks) to  increase at rates that are unsustainable.  By borrowing in the 80's and 90's individuals, corporations and the U.S. government have borrowed from the future to pay for their past spending sprees.  

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