By John Early at Seekingalpha.com
When you overestimate earnings by 20% and the growth rate of earnings by two or three times it is easy to make stock prices look reasonable. Using measures of valuation that have stood the test of time shows stocks are overvalued and the best measure of valuation I have found says they are more overvalued than at the peak in 1929. However, in the short term momentum trumps valuation and even though stocks are priced high they could continue going up. When momentum exhausts itself stock prices will fall far below where they are now.
The preferred measure to show stocks are cheap is a PE (price earnings ratio) based on forward or estimated operating earnings. While the concept of using operating earnings to value stock is reasonable and theoretically better than actual or “as reported” earnings, in practice a PE using operating earnings has developed a blatant bullish bias that masks overvaluation. First of all, operating earnings have become a tool used to avoid showing an increasing share of expenses. In addition, the forward estimates are unrealistically rosy. Finally, what seems today to be a favorable level of valuation is measured against a short history in which U.S. stocks were well above normal valuations.
Operating earnings exclude certain expenses, for example losses from a line of business that is not continuing. When they were first calculated back in 1988 operating earnings were about 1.5% higher than as reported earnings. In the first 12 years operating earnings averaged 10% higher than “as reported” earnings. In the last 12 years they have averaged 21% higher. It seems with each recession, when earnings turn down, companies are figuring out how to exclude more expenses from operating earnings. Consider the progressively larger gaps (in the chart below) between the green line showing operating earnings and the black line showing actual earnings that occur around recessions.