Valuation going into 2nd Quarter Earnings

Well here we are… seems like yesterday we were scrambling to figure out how the government could change all the accounting rules for the banks and basically legalize Enron-esque practices.. and as if that wasn’t enough the government started loaning to the banks for basically 0% while they turned around and lent that money for 5%. With that kind of preferential treatment a monkey in diapers could make money. (No offense to you monkeys out there) Since last quarters earnings season and pre Q1 earnings season antics mentioned above the financials (XLF) have rallied 83% from there lows and the market followed, as usual, to the tune of 33%.

So now with all that in mind we are starting Q2 earnings season and Im so excited for beat the street  by a penny time!  I can almost hear Maria B. and the gang at CNBC saying the classic lines, such as “It could have been worse.”  For example last years Alcoa earnings announcement of such after the company went from Q1 2008 making 44 cents per share to losing 60 cents per share…. thats a year over year drop of 236% !!   The stock rallied the next day.

Below is a chart from Doug Short over at dshort.com that shows the P/E ratio over time using the P/E10 method, which is explained further on the full post.

Below is some explanation from Doug Short:

The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic P/E10 average is 16.3.

Where does the current valuation put us?
For a more precise view of how today’s P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles – five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? Over the past several months, the decline from the all-time P/E10 high has dramatically accelerated toward value territory, with the ratio dropping from the 1st to the upper 4th quintile in March.

A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 600. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its ninth year.