Operating Earnings and OPM

This thought from Henderson Global Investors reflects the Sentiment of the Day

"Equity markets had gone up a lot and almost uninterruptedly since last June and some markets had perhaps become a little expensive, creating the right climate for a fall."

Yes operating earnings look great, arguably never better. Nonetheless, valuations are more than a "little expensive" and there is no "perhaps" about it. John Hussman of Hussman Funds explores this idea, along the the Yen Carry Trade and OPM (Other People's Money) in Rapunzel Gets a Trim

Operating Earnings and OPM

A few comments about prevailing bullish themes here. Probably the main bullish theme at present is the misguided focus on "forward operating earnings," which create the impression that stocks are reasonably priced. This piece of bait contains a very long, sharp hook, which is likely to keep many investors on the line well into the next bear market.

Expectations for future operating earnings assume that current, record high profit margins will not only be sustained, but will expand further. Yet even when earnings ultimately fall short, analysts will be under no obligation to lower their "forward" expectations, at least initially. The resulting illusion of cheap valuations, fairly early in the next bear market, is likely to keep a great many investors holding on deep into the decline (whenever it begins in earnest). As in many other bear markets, earnings will probably decline convincingly only after a great deal of damage has already been done.

I cannot emphasize enough that price/earnings ratios, especially those based on "forward operating earnings," are unusually poor metrics of valuation at present.

A related theme is the notion that stocks must be good values because of the private equity buyouts we've been observing. It's important to understand that these buyouts are being done with OPM – other people's money – and that the main factor driving them is not low stock valuations but low risk premiums. Risky debt can currently be issued at interest rates barely above the low yields on default-free Treasuries. This will certainly end badly for investors in low-rated credits (as companies that issue sub-prime mortgages are beginning to realize). It is no indication of attractive stock market valuation.

What happens over time is that forward earnings keep getting ratched up and up over time as if improving conditions can go on forever. We saw this with homebuilders and subprime lenders already. Though those sectors have now imploded.

For unexplained reasons (most likely because there is no sensible reason) we are told by Bernanke, Greenspan and a choir of cheerleaders on CNBC that housing weakness will not spread over into other sectors. How can it not spread into other areas? A trillion dollars worth of property is going to see huge increases in interest rates this year, real estate agents without sales have little to no income coming in, mortgage equity withdrawal (MEW) has all but dried up, and home prices are declining even as property taxes are rising. Furthermore, each decrease in home sales means less furniture, less trucking, and less appliances that are needed, etc.

Nonetheless speculation with OPM continues. After all there are lucrative fees to be made underwriting these deals, 20% fees on profits by hedge funds, and big management fees (because of enormous assets under management) by mutual funds. If any of these blow up, who cares, it's your money not theirs.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/