Margin of Safety ?

A solid article over at Clusterstock by Doug Short, showing why stocks aren't yet so cheap.

Doug says:

. . . in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. "Why the lag?" you may wonder. "How can the P/E be at a record high after the price has fallen so far?" The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500. And Standard & Poor's earnings estimates for July through September will give us negative annual earnings. A P/E calculated with negative earnings would flip the ratio past a divide-by-zero error to a negative ratio. Make that nonsense squared!

So Doug digs up Graham's PE10, adjusts for inflation and then shows where we're really at.

Doug goes on to say:

. . . 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.

Corporate earnings rebound? Not any time soon. . . Bill Gross, in his July '09 PIMCO outlook says:

"I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, 'How do you put together a consumer economy that works when the consumers are out of work?' That is really all one needs to ask when divining our economy’s future fortune."

David Gaffen over at Global Investing further makes the case for a bearish earnings outlook.

So if you agree that corporate earnings are not going anywhere soon, then the recent market rally has been built on multiple expansion and little else.

And multiple expansion is the flip-side of yield compression. If you believe inflation isn't too far away (because of QE), systematic risk has not decreased, and don't believe in an earnings rebound, then this yield compression is built on false hope.

So what have we then? A paradigm shift? A structural break to a new set of rules? Felix Salmon, Robert Reich, and Mohamed El-Erian certainly think so. They go further than Roubini with his alphabet soup of recovery letters, than Soros with his "stop-go economy" thesis and think that the old-normal will not return and that we now have a New-Normal and face an X-shaped recovery.