Earnings Deflation -- Economic Commentary by John Mauldin

Earnings season is upon us, and with each announcement the market seems to surge on new ecstasies or retreat with disillusionment. Each new announcement is cut open, like so many sheep, to see what its entrails will divine to us about the future, as if one more bit of fresh data will give us the clear forward vision we think we so desperately need. Is the bull finally back? Are we climbing a wall of worry, or just on another fool's errand, rising in a bubble toward the inevitable pin? Yet, earnings are up by more than 100% since the end of the last recession. How can we not be optimistic?

Today's letter will show that projecting recent past earnings growth too far into the future is a prescription for pain. I have to admit to being surprised by some of the facts with which I will present you. I bet 98% of you will be surprised as well. These are facts you need to know.

And I will end with some very optimistic and brief stories. They are examples of why I can be such an optimist, even as I tell you we are in a secular bear market. But before we jump into the numbers, let's read this one paragraph, which shows us the more things change, the more they stay the same. (Sent to me by my friend, Bill King)

On January 7, 1946, the famous novelist and writer John Dos Passos of Life Magazine penned a piece entitled "Americans Are Losing the Victory in Europe". The article quotes US GIs to highlight low morale among the troops. "The troops returning home are worried. 'We've lost the peace,' men tell you. 'We can't make it stick.' The French press is skeptical about US governing and rebuilding of Germany. "You try to explain to these Europeans that they expected too much...They don't blame us for the fading of that hope. But they blame us now...We have swept away Hitlerism, but a great many Europeans feel that the cure has been worse than the disease."

"Never has American prestige been lower in Europe. People never tire of telling you of the ignorance and rowdy-ism of American troops, of our misunderstanding of European conditions. They say that the theft and sale of Army supplies by our troops is the basis of their black market. They blame us for the corruption and disorganization of UNRRA. They blame us for the fumbling timidity of our negotiations with the Soviet Union. They tell us that our mechanical de-nazification policy in Germany is producing results opposite to those we planned. 'Have you no statesmen in America?' they ask."

You can read the entire (and yet all too brief) article at (http://www.kultursmog.com/Life-Page01.htm). Then think Iraq. I would especially encourage my international readers, and those in the US skeptical of Bush Administration efforts in Iraq, to take a few minutes to read this. It will help put things in perspective. And now on to the more mundane world of money and investing.

"Following Benjamin Graham's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.

"As Ben said: 'In the short run, the market is a voting machine but in the long run it is a weighing machine.' The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate."

What the market weighs in the long run is earnings: old-fashioned in-your-pocket earnings. Secular bear markets are part of the long run, and as we have seen, can be very frustrating for buy and hold investors. Earnings matter more and more as the bear market cycle drags on.

In numerous previous letters, I have made the case that we should look at a secular bear market not just as a decline in stock prices, but as a declining Price to Earnings (P/E) ratio. The ratio declines as investors increasingly become more conservative in their view of earnings, and more skeptical in their optimism about the future. The balancing factor is that earnings will grow over time as well, so that over time (a long time) earnings become "cheap" and a new bull market begins.

The news is not all bad. There are very sound reasons to think that earnings for US business in general will double (or more) over the next 20 years and considerably more so for some sectors. The bad news is that this is nowhere close to what most analysts are now predicting.

Think of earnings like a glass ceiling. It is hard to see, but it is definitely there. In bull market cycles, these ceilings are shattered as investor concerns about future earnings decrease and optimism increases. In bear market cycles, the market continually bumps up against this barrier to growth, and no amount of cheerleading can remove that barrier.

Thus the key for growth in stock market prices in the future is the quality and quantity of earnings. The higher that both the level of earnings and the growth in earnings are, the less the stock market will fall over time and the sooner the next bull market can begin.

The first thing we need to do is decide how we are going to measure earnings. The market would like you to look at "pro forma" earnings. Some call this standard "Earnings Before Bad Stuff." I like to call it "Earnings Before Interest and Hype." Some suggest you look at EBITDA earnings as a type of pro forma earnings: Earnings Before Interest, Taxes, Depreciation and Amortization, as if those are somehow not real financial events. Either way, this lets companies report earnings to the public and exclude certain items that actually show up on their tax returns.

The second category is reported earnings, which are earnings as reported to the IRS (which deduct options expense, by the way).

The third category is "core earnings" which S&P, among others, is starting to use. S&P announced in 2002 they intended to start reporting earnings using this new standard which deals with options and pension liabilities, in advance of it being adopted by the accounting industry.

I believe that in the future the new "gold standard" for earnings will be the S&P core earnings standard. "Not fair," say the bulls. "To get true historical comparisons, you have to compare apples to apples. The new standards distort the actual profitability of a company, and give us no fair historical comparison."

To that, I politely say bunk. Pre-1990, and especially if you go past 1975, pension benefits did not have nearly the impact that they do today; there was not that much over-funding and estimates of future earnings on pension fund holdings were far more conservative. Looking at data prior to 1990, there was little difference between pro forma and reported earnings. It was only in the 90's, the decade of financial engineering, where a CEO could create a 10% rise in his company earnings just by changing the assumptions of his company pension fund. These elusive pension fund earnings started to show up in the profits in a significant way.

Of course, that helped the CEO's personal options, which again the company did not have to expense. Options were not a big deal prior to 1980 and not all that significant even until 1990. Prior to those years, after tax or reported earnings were essentially core earnings.

Accounting standards always tighten up in bear markets. Investors become more conservative. They are not willing to project earnings growth far into the future. That is why the market drops. We will go into pensions and options later in this chapter, but for now, let's look at recent earnings history and see if reality matches expectations.

In the third quarter of 2002, S&P released their study of earnings for the S&P 500 for the four quarters ending in June, 2002. Instead of the pro forma $44.93 that Thomson First Call reported, S&P said actual reported earnings were $26.74 a share. (Thomson First Call estimates come from Wall Street analysts. Despite investigations and being clearly shown to be wrong so often, most are still clueless, and still shameless cheerleaders.)

Earnings were $26.74, that is, until S&P deducts option expenses and pension liabilities from the companies in their own index, and that drops earnings to $18.48 a share. Over one year later, subsequent revisions have dropped core earnings to $17.79 per share for that period. Depending upon what date you chose in the fourth quarter of 2002, this was a Price to Earnings (P/E) ratio of well over 45 on the S&P 500. That was clearly still stock market bubble territory.

Did things get better the next 12 months? Yes, undeniably better. For the 12 months ending September 30 (assuming estimates are correct), core earnings will be 37.71. Now, even if we shave off a few points for the inevitable downward revisions, that is clearly a double from the previously cited period. (xxx- change to end of 2004 if possible)

Pro forma earnings growth over the same period (15 months) was up over 23% (from $41.59 to $51.27) and reported earnings (after tax) was up 39%, to $37.21.

Whichever earnings standard you prefer to use, earnings jumped significantly in the 18 months since the end of the recession. Investors are once again excited about the market, projecting strong earnings growth well into the future. At the end of 1999, the P/E ratio was 30.5 (on an after tax, as reported basis). In October, we find investors once again pricing the market close to 30.

And why not? Earnings growth is clearly back. Given the recent growth, it is not hard for many investors to think earnings can once again grow at 15% a year, which will mean they double in under five years. The economy is sailing at full speed. Inflation and interest rates are low. The Fed has clearly told us they intend to keep rates low for some time. What more can an investor want? The bull is back.

Except if you look at the numbers for a little longer than 18 months, you find that earnings growth evaporates. I decided to see what earnings actually grew at during the bull market. I must confess that the following facts surprised me when I first pulled them from the spreadsheets. I truly expected earnings to grow by around inflation plus GDP which, as I have shown, is slightly higher than the historical average of actual earnings growth. We have, after all, been through a great period of economic growth. I was wrong.

As reported earnings per share for the 12 months ending in September was $37.02. For the 12 months of 1996 it was $38.73. For the next almost 7 years since 1996, per share earnings have managed to slump almost 4%. Inflation was 13.7% for that period. In inflation adjusted terms, per share earnings dropped almost 19%. That means the dollar in per share earnings that you received in 1996 has lost significant buying value in just seven years.

Pro forma earnings rose over 20%, though, which simply means that companies choose to tell investors that most of their earnings difficulties are one time events and that you should ignore them. Next year, we are promised, we won't have different one time event problems.

Core earnings did manage to rise 3% over those 7 years. Not per year, mind you, but in total. This is a compound growth rate of less than 0.5% per year, which is well south of 15%.

I have a small confession. I have a second love, and one of which my bride is all too frustratingly well aware. I love numbers. I am one of those guys who count the number of tiles in the ceiling, who looks for relationships between all sorts of various and sundry statistics and I really, really love to look at tables. Things seem to jump off the page when you look at historical tables.

One of my favorite tables is the earnings tables for the S&P 500 at www.standardandpoors.com. (Note: you will have to navigate a little bit, but you can find them, or you can type in: http://www2.standardandpoors.com/spf/xls/index/ SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&)

They only have data in these tables on the S&P earnings going back to 1988. But it becomes quite instructive. Remember that 1988 was the first year after the '87 crash, and the beginning of a rather huge bull run.

Operating earnings for 1988 were $23.75. The S&P ended the year at 277. Thus, in 15 years the earnings grew by 56% or very close to 3% per year.

Inflation from 1988 through the end of 2002 was 52%. What cost $100 in 1988 would cost $152.01 in 2002. Also, if you were to buy exactly the same products in 2002 and 1988, they would cost you $100 and $65.78, respectively.

If earnings only kept up with inflation, they would grow from the $23.75 in 1988 to $36.10 in 2003. That means that earnings barely kept up with inflation, growing less than $1 ($.92) in real, inflation-adjusted terms in 15 years! That is a total growth of less than 4%, and clearly a real compound growth of less than 0.5%.

Thus, over 96% of the earnings growth in the S&P 500 for the last 15 years was simply due to inflation!

Mind you, this period included the economic miracle period of the 90's, the scene of the largest boom and financial bubble in history. The US GDP grew from $5.3 billion to over $10.8 billion. Inflation counted for much of that growth. If the US economy only grew at the rate of inflation, it would be roughly $8 billion today. So slightly more than half the growth of the economy over the last 15 years has been "real."

The earnings on the S&P 500 failed to grow anywhere close to inflation plus GDP.

The price of the S&P 500 was 277 at the end of 1988. If it had only kept up with inflation, it would be down around 421 or so at the end of 2003. Yet, it has actually risen about 2.5 times that amount, even after the bear market corrected some of the bubble excesses. The P/E at the end of 1988 was 11.69. As noted above, in October of 2003 it was very close to 30.

Running the numbers we find that almost 80% of the rise in the value of the S&P has been due solely to increasing valuations. Investors are willing to pay a great deal more for a dollar of earnings in 2003 than they did in 1988. Presumably they do so because they expect those earnings to grow faster than they have in the last 15 years.

If you go to www.decisionpoint.com (one of my favorite services), you can see in one of the many hundreds of charts available that if the P/E ratio for the S&P 500 were 15, about average for the last century, the market would have been at 420 on April Fools Day of 2003. As markets have always over-corrected, generally to below single digit P/E ratios, if it went to 10, the S&P 500 would have been at 280, down 68% or so from where it was. That is pretty ugly.

Given future earnings estimates, if the S&P were to return to its historical P/E average, the number for April Fool's 2004 should be up to the area of 600, as earnings are rebounding off their depressed lows since the last recession. Remember, history teaches us that stock valuations always and eventually regress significantly back below their averages.

I believe we are going to single digit ratios. I also believe it will take a decade or more, just as it did in the 70's and in past secular bear markets. During that time, earnings will grow, and probably double or more (without having to be too optimistic). What happens in secular bears is that earnings grow and P/E ratios drop. But it does not happen all at once. It takes time.

We can be thankful for that, because if the markets were to drop 68% today, we would be facing a depression as severe as our grandparents faced. It would be ugly, ugly, ugly. Thus, in a kind of perverted logic, we should be grateful for market cheerleaders, as they prop up the economy and stave off a disaster scenario. But as individuals, we don't have to listen to them.

The hope of a return to a bull market and a comfortable retirement is why bear markets take years to finally end, and not months. It will take at least two more recessions before investors finally give in and we see the bottom of this one. And for that we should be grateful. If the Dow went to 4,000 next week, we would be in for a severe recession or even a depression very quickly. Because things will drag out for years, we will "enjoy" milder recessions and a Muddle Through Decade. Because you understand what is happening, you can adjust your portfolio accordingly, and do quite well in the meantime. But I feel sorry for those other guys.

No bull market has ever started from such high valuation levels. It is at the core of why I think the recent rise in the market is a bear market rally. It will continue to be a secular bear market until we see a rise in real earnings for an extended period of time.

Our whole view of the value of the market and predicted future growth has been colored dramatically by the recent bull market, and even now has yet to be materially altered. I once again ask a familiar question to long time readers: How many times have you had a stock broker quote you the Ibbotson Survey or something similar which shows the stock market growing 6.7% or 9% or more per year over long periods of time? All you have to do is just keep the faith and buy and hold. You should especially never sell their funds.

Peter Bernstein and Robert Arnott, in a very thoughtful article in the Financial Analysts Journal show that this number is VERY misleading. If you break it down, it shows you something entirely different.

First, the largest component of stock market return, up until 1982, was inflation. From 1802 to present, $100 would have grown to $700 million if you assumed all dividends re-invested. If you take out inflation, we are left with a still impressive $37 million. If you take out dividends, however, you find that your $100 is only worth $2,099!

Here's the kicker: in 1982, the stock portfolio would have been worth only $400. The bulk of the growth, over 80% of current value, came in the last 20 years.

This data simply says that conventional wisdom, which says equities get most of their value from capital appreciation, is false. It is based upon recent experience, and a bubble mentality.

And now, let's look at some good news. Bill King, normally of a rather bearish persuasion, published these good news items in one of his recent daily missives of The King Report. Yes, earnings growth of large firms may be suspect, but there is plenty of entrepreneurial activity in the world, and the future foundation for large companies which will reward their investors is even now being laid. Will it be these firms, or their competitors, who become the next Microsoft or Amgen?

John Jorsett of The Scotsman reports, "A team of scientists has discovered a completely new way to make electricity from nothing more than flowing water. The breakthrough, the first new method of electricity production for 160 years, could provide free, clean energy for devices such as mobile phones and calculators. On a large scale, it could conceivably be used to feed power into the national grid. Dr David Lynch, Dean of the Faculty of Engineering at the University of Alberta in Canada, where the technology was developed, said: "The discovery of an entirely new way of producing power is an incredible fundamental research breakthrough that occurs once in a lifetime...The system relies on the natural "electrokinetic" effect of a fluid flowing over a solid surface. An interplay of forces results in a thin layer of water - where it meets the surface - with a net electric charge." http://www.news.scotsman.com/latest.cfm?id=2071354

AFP: "French scientists using an innovative microscopic scanning technique say they have discovered that nerve cells almost buzz with molecular agitation when they communicate with each other. The work sheds light on how cells operate at the synapse ...But nanotechnology, harnessed to a video camera by French researchers, shows the receptors to be extraordinarily active and that they even move around dynamically on the membrane surface."

Ian Hoffman of the Oakland Tribune reports, "...defense scientists are on the cusp of what could be a military revolution -- warfare at the speed of light. 'We've made a quantum leap here,' said Randy Buff, solid-state laser program manager for the U.S. Army's Space and Missile Defense Command. 'We're anxious to get out there and do something.'... By coaxing a huge power boost out of tiny laser diodes like those in CD players, scoreboards and supermarket scanners, scientists are squeezing unprecedented power out of lasers made of exotic crystals...The latest breed of solid-state lasers now are poised to break the dominance of giant, chemical gas-powered beams with compact, mobile weapons that can run off a Humvee's diesel engine or a jet fighter's turbine. Experts liken this evolution to the shift from 1950s vacuum tubes to the solid-state transistors now driving everything electronic." http://www.oaklandtribune.com/cda/article/print/0,1674,82%257E1865%257E1709759,00.html

The BBC's Ania Lichtarowicz reports, "Scientists in the United States have developed a new way of taking medicines which could improve the effectiveness of some treatments including HIV therapy. Swallowing pills could become a thing of the past. Writing in the journal Nature Materials they describe a drug-containing microchip which can be implanted in the body. This then releases the medication slowly so the patient no longer has to take any pills."

AP: "One minute Gary Formanek was hitting balls at an Oregon driving range. The next, he was lying on the ground, his left side paralyzed from a stroke. The only drug that treats strokes didn't help. So doctors snaked a tiny corkscrew into Formanek's brain and pulled out the stroke-causing clot. The device that saved Formanek from disability, if not death, is generating excitement among brain experts who say the novel technology might finally offer hope for the most devastating strokes. Called the MERCI Retriever, it's still experimental. But in early testing, it seems to restore blood flow in almost half of patients - people who couldn't be helped by today's only stroke-busting medication."

Science Daily: "Chemists at Rice University have demonstrated that disordered assemblies of gold nanowires and conductive organic molecules can function as non-volatile memory, one of the key components of computer chips. 'A large part of the cost associated with creating integrated circuits comes from the painstaking precision required to ensure that each of the millions of circuits on the chip are placed in exactly the right spot,' said lead researcher Jim Tour, an organic chemist at Rice. 'Our research shows that ordered precision isn't a prerequisite for computing. It is possible to make memory circuits out of disordered systems.'" http://www.sciencedaily.com/releases/2003/10/031020053847.htm

And yesterday I read in USA Today that scientists have discovered a test which accurately predicts the likelihood of a heart attack for someone with chest pains, thus offering the potential for significantly lowering the death rate from the #1 killer.

Next week I leave for the always fascinating New Orleans Investment Conference. I will be meeting with a number of readers and clients, but there are still a few slots left open. Halloween in New Orleans should be something of a hoot. I am making good progress on the final drafts of my book. I am scheduled to have it finished by November 14, and then on to the publisher for editing and printing, etc. Hopefully, we will have a title by then as well. The marketing types have not been able to settle on one as yet. I am sure as the date gets closer I will get more panicked and further behind in my work, as the End of the Book-writing World As I Know It approaches.

I notice that Bill Bonner's book, Day of Reckoning, is #9 on the Wall Street Journal list, and is poised to crack the top ten on the New York Times. I have had a lot of you write and thank me for recommending the book. It deserves the acclaim it is getting. You can get the book at your local bookstore or at Amazon.com: http://www.amazon.com/exec/obidos/ASIN/0471449733/frontlinethou-20

This is #2 son's birthday weekend. I can't believe he is already 15. It seems like only yesterday he was acting like a 6 year old. Wait a minute, it was yesterday. Oh, well, have a great weekend. See some friends and remember to have some fun.

The news is not all bad. There are very sound reasons to think that earnings for US business in general will double (or more) over the next 20 years and considerably more so for some sectors.

. . . there was little difference between pro forma and reported earnings. It was only in the 90's, the decade of financial engineering, where a CEO could create a 10% rise in his company earnings just by changing the assumptions of his company pension fund. These elusive pension fund earnings started to show up in the profits in a significant way.

Except if you look at the numbers for a little longer than 18 months, you find that earnings growth evaporates.

Thus, over 96% of the earnings growth in the S&P 500 for the last 15 years was simply due to inflation!

Mauldin says that we are in a secular bear market that will last for years and that fair value for the Dow is 4000 and the S&P is 600 (in April of 2004). This could be very painful.

Richard W.

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