Jewish World Review April 9, 2003/ 7 Nisan, 5763

David R. Kotok

David R. Kotok
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Consumer Reports

The "E" in P/E. Is the Market "Rich" or "Cheap?" | The "E" is "$28 in 2002 GAAP earnings or $23.75 in 'core earnings' or "$46 in 2002 operating earnings?" No says Ned Davis; "I am using $37 for 'normalized' S&P 500 earnings." This is his 2002 number.

What shall we do about earnings estimates? We get this question continuously.

Let's add to the complexity. The combined earnings of three companies in the S&P 500, GE, C & XOM, exceed the bottom 250 members of this benchmark index. Thank you, Morgan Stanley, who, by the way, estimates 2003 operating earnings at $52 and 2004 at $55.

Once we have an "E" we can look at the "P" and quickly calculate a number. At 880 on the S&P 500 we get a 16 P/E on next year's operating earnings using the Morgan Stanley estimate.

Then the debate starts anew. Is that "rich" or "cheap?"

Most say the market seems expensive by historical standards. The bubble bursting of the last three years has not done enough to bring the market to the "cheap" zone. Bulls retort that interest rates are low and when rates are low we should allow that the P/E can be higher than historical averages.

Nope say the critics.

Low interest rates mean low inflation rates and that means low nominal growth rates which means low earnings growth rates. "You can't have it both ways" says the critic.

Cumberland looks at the economic profit series calculated by the Bureau of Economic Analysis and relates it to a percentage of BEA's estimate of the nation's GDP. Over time this number seems to fluctuate between 4% and 7% and tends to run in long cycles. Markets tend to rise when this percentage is rising and fall when the reverse occurs. This method warned us of the bubble and gave us plenty of time to avoid the debacle. Using this method now indicates that stocks seem to be priced at a reasonable level. The trend since the 9/11 attacks has turned upward and is presently around the midpoint of its historic range. If the economy grows, and if the tax policies of the Bush Administration get through Congress, the economic profits of American enterprise should improve. So should the stock market.

In a terrific research piece, Art Laffer and Marc Miles, have addressed the critics' issues. They include the low interest rate concern and the tax code changes as part of their analysis entitled "Five Factors Distorting P/E Comparisons Over Time."

Laffer concludes with a poke at Bill Gross' Dow 5000 forecast and why it is wrong. We agree with Laffer.

We are maintaining our view that the long term level of Dow 7200 to 7400 represents the bottom of the market's range. This level has been successfully tested several times starting in 1998 and as recently as the immediate pre-Iraq War month.

JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.


03/20/03: The War economy, then and now: WW II and War on Terror
03/06/03: What will the larger deficits do to interest rates?
02/24/03: There are 2 Two Front Wars!
02/05/03: Financial predictions during war time
01/23/03: Keep your eye on the U.S. dollar
01/16/03: Bush plan and tax-free bonds: Impact negative.
12/13/02: Frequently Asked (financial) Questions
12/11/02: The Fed, The New Bush Folks, The Policy
12/05/02: Five easing pieces
11/26/02: Lessons Learned at The Philadelphia Fed and an update to our strategic outlook
11/22/02: What happens when you mix politics and municipal bonds
11/20/02: Secular vs. Cyclical Bull and Bear Markets
11/14/02: Please stop bashing the ECB!
11/08/02: Fed may have taken themselves out of debate but they've added to uncertainty by surprising the markets
11/07/02: The election and the Fed: Both validate stimulus
10/31/02: Welcome to the world of an enlarged and open Europe

© 2002, David R. Kotok