Will Analysts' Irrational Exuberance Sink the Dow?

Sure, the Dow had a huge day on Tuesday, but we're far from being out of this bear market. One factor that could put downward pressure on stock prices in the months to come stems from analyst earnings estimates for 2009, which remain much too optimistic.

Inevitably, these estimates will have to come down as analysts are forced to get acquainted with the two elephants in the room -- a swiftly deteriorating economy and a structural decline in the profitability of financial companies. In that context, is the Dow still overvalued after having lost more than a third of its value during the past 12 months?

Normal margins and other fairy tales
According to GMO Chairman (and famous "bear") Jeremy Grantham, "The I/B/E/S earnings estimate for the S&P over the next 12 months is still $98.50 a share. At even normal margins it would be $71, and at margins 20% below normal it would fall to $56." (Thomson I/B/E/S is the reference source for consensus earnings estimates.)

Blimey! Given the way the economic environment is shaping up, it seems naively optimistic to bank on above-normal corporate margins in 2009 -- Grantham's "20% below normal" sounds a lot more realistic. All other things being equal, the difference between $98.50 and $56 in earnings is the difference between the S&P 500 at 930.09 (yesterday's closing price) and the S&P 500 below 530. Ouch.

7 stocks at risk
Would you like specific examples of analysts' myopia? The following table shows seven Dow components for which earnings forecasts could fall hardest, as they currently exhibit the widest spread between analysts' consensus estimate and the lowest analyst estimate:

*In cases in which the fiscal year doesn't match the calendar year, the fiscal year 2010 estimate was used.
Source: Capital IQ, a division of Standard & Poor's.

In looking at the valuation of the Dow Jones Industrial Average, I used the same data to correct for analysts' rosy bias. To get a more realistic estimate of Dow earnings, I took the lowest analyst earnings estimate for each of the 30 Dow components and summed them.

The following table contains the results. Below each earnings figure, the corresponding P/E multiple based on yesterday's closing price for the Dow is shown in bold:

First, note that there is a significant difference between the low and the average estimate -- nearly 30% if we include negative earnings. To refer back to a comparison I used earlier, that is the difference between the Dow at 8,991 (yesterday's close) and at 6,361. Now that we have a figure for the earnings per share, what is an appropriate price-to-earnings (P/E) multiple?

This isn't August 1982
In the postwar era, the low for Dow P/Es -- 6.7 -- occurred in August 1982. If we were to revisit that and use $741.92 for the Dow earnings, the index would fall to a little more than half of yesterday's closing price -- 7.0 x 741.92 = 4,971.

Is it possible that we could see that level? Yes. Is it likely? I don't think so. Keep in mind one crucial distinction between these periods: In August 1982, the risk-free rate (the 30-year Treasury bond yield) exceeded 13% -- more than three times today's risk-free rate of 4.2%. That makes an enormous difference.

Why? The higher the risk-free rate is, the lower the P/E multiples should be. Look at it this way: The higher the return you can earn without taking any risk, the higher the hurdle for risky investments such as stocks -- or, for example, as T-bond rates rise, the cheaper stocks need to become to be equally attractive. Cheaper stocks mean lower P/Es.

My 3 conclusions

1. Don't rely on consensus earnings estimates right now -- they are hopelessly biased to the upside.
2. Despite what I said in the first point, don't pay too much attention to doomsday scenarios according to which the stock market remains highly overvalued. Stocks can go lower, of course, but that would be a triumph of market psychology over market fundamentals. With 30-year Treasury bonds yielding just above 4%, a Dow P/E somewhere in the range between 12 and 16 (see the first column of my second table) doesn't suggest to me that stocks are highly overvalued, if at all.
3. Finally, I look at stock market indices on an indicative basis, but I don't place bets on them. If you believe, as I do, that the current level of the stock market suggests there are individual stock bargains to be had, you're better off channeling your time and energy finding a few diamonds amid the market rubble.

More Credit Crisis Foolishness:

• Roundtable: 3 Insanely Undervalued Industries
• What to Do When the Dow Hits 7,500