Apples to Elephants

Hussman Funds - Weekly Market Comment: May 30, 2006 - Apples to Elephants: "Among the frequent bullish arguments from analysts these days is the notion that stock P/E ratios are fair or even low – an assertion that is often made so straight-faced that you get the definite impression that the analysts actually believe it. And why not? It's well known that the historical average P/E ratio is about 15, so why not compare S&P 500 valuations to that benchmark?
Unfortunately most analysts base their P/E measures on “forward operating earnings.” 'Forward' meaning next year or even two years out. 'Operating earnings' meaning a measure not even defined under generally accepted accounting principles – GAAP – that typically excludes anything that reduces the predictability of earnings, and certainly excludes “extraordinary losses” even if those losses are taken routinely. The resulting, whitewashed earnings measure can easily be 25% or more above trailing net earnings (the prior-year's earnings as defined under generally accepted accounting principles).
As Anne Casscells and Cliff Asness pointed out a couple of years ago, it's absurd to compare P/E's based on “forward operating earnings” with a historical average P/E based on “trailing net earnings.” Asness calculated that the historical average P/E on forward operating earnings is closer to 12, and is probably lower since the average includes the late-90's bubble, but excludes valuations prior to the late 1970's (which is the earliest the data is available). Given that my own measure – price/peak earnings – has averaged less than 10 when S&P 500 earnings have been close to the top of their long-term 6% peak-to-peak growth channel, my guess is that the appropriate norm for forward operating P"