Stocks: Over-Loved and Under-Valued?

The gap between projected 12-month profits and average earnings over the last 10 years is set to widen the most since 1951

Look at price charts and you'll see that stocks are loved. Look at the VIX and you'll see that stocks are carelessly loved.

Careless love is reflected in a recent Bloomberg article, which identified the most explosive profit growth in the past century. This profit explosion is happening right here, right now. As per this article, now is not the time to be selling stocks because they are cheap.

Careless love often results in unwanted consequences, so we do well to examine the “stocks are cheap” assertion. According to Bloomberg, “The gap between projected 12-month profits and average earnings over the last 10 years is set to widen the most since 1951.” Projected earnings are expected to clock in at a record $91 for S&P 500 companies.

Before you trigger the “buy everything now” button, think about the above statement for a second. If the gap between projected profits and average earnings is the biggest since 1951, it means that it’s bigger than in 2000 and 2007, which noted major market tops and were followed by sizeable declines.

If you graph this out, you would see three spikes; one pop in 2000, one in 2007 and one now. Every time the spread spiked to new highs, stocks fell hard. Keep in mind that the spread is based on projected earnings. Projected earnings are about as certain as a politician’s promise.

How accurate are analysts’ and earnings projections? Days before the March 2009 low, Goldman lowered its earnings outlook for the S&P from $113 incrementally to $40. Bank of America Merrill Lynch lowered its estimate to $46 and Citigroup lowered to $51. At the same time – on March 2, 2009 – the ETF Profit Strategy Newsletter sent out a special buy alert and recommended loading up on stocks.

Analysts tend to be overly bullish at market tops just as they are overly bearish at market bottoms. Based on Standard & Poor’s data, earnings actually peaked at $87 in 2006 and never reached Goldman’s projected upside target of $113. Earnings also bottomed before they reached Goldman’s projected down side target of $40.

Basing valuations on projected earnings is like counting un-hatched chickens. Let’s take a look at P/E ratios with substance, such as Robert J. Shiller’s cyclically-adjusted P/E (CAPE) ratio with a 110-year history. Shiller’s CAPE is over 40% above its 110-year average. Professor Shiller considers the S&P to be 41% over valued.

Valuations are always mean reverting. As such, owning stocks at current prices is risky even though – or rather because – analysts expect earnings to rise.

Whenever rich valuations rendezvous with optimism and complacency, investors should become extra cautious. The ETF Profit Strategy Newsletter identified three such occasions over the past 15 months – January 2010, April 2010, and February 2011.

Each time, stocks declined between 7 – 20%. However, all three declines turned out to be head fakes and optimistic analysts’ projections haven’t been as reliable as contrarian indicators as they were in March 2009 and late 2007. This is probably due to the Federal Reserve’s QE2 liquidity.

Now once again the VIX is in dangerous territory and QE2 is coming to an end. When investors – retail and institutional – start unwinding some of their hefty stock holdings, the “too good to be true” syndrome might multiply like a malignant cell and overwhelm the exchanges with sell orders.

This doesn’t mean stocks can’t go higher in the short-term. In fact, it would be great to see the S&P rally to its ideal target range. The ideal target range is comprised of a multi-decade trend line and important Fibonacci resistance. If the S&P is able to rally into that range, it would have exhausted its up side potential and eliminated an obvious reason to come back anytime soon.

The ETF Profit Strategy Newsletter provides a short, mid and long-term forecast along with target levels of resistance and especially support – that once broken – is likely to result in rapidly falling prices.

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