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(thanks to "sharefin" for spotting this one.)
http://www.decisionpoint.com/ChartSpotliteFiles/020712sppe.html
ANATOMY OF A BUBBLE: WHERE IT ALL WENT WRONG
The charts on this page show the S&P 500 (black line) in relation to its normal
P/E range. The lines composing the channel show where the S&P 500 would be if
it were overvalued (red line), undervalued (green line), and fairly valued
(blue line). The three charts below show that the S&P rarely moves outside that
range. When it does, it signals extraordinary risk (higher than the channel) or
extraordinary value (lower than the channel. Also, the direction in which the
channel is moving tells us whether earnings are expanding or contracting.
The top chart shows the period of the largest valuation bubble in the history
of the U.S. stock market. In the early 1990s prices rose, pushing the top of
the envelope higher, correctly anticipating earnings growth. In 1997 earnings
peaked, but prices experienced a reality disconnect and kept rising with no
regard to earnings.
You will note that there was a surge in earnings from mid-1999 through 2000. It
is only speculation on my part, but my guess is that earnings spurt was
primarily the result of creative accounting, not an increase in earnings.
Earnings were exaggerated on the upside of the bulge in the hope that they
would eventually catch up, but that hope was unfulfilled and there was an
apparent earnings crash as companies surrendered to reality. I have drawn red,
blue, and green dotted lines to connect both sides of the bulge. Note how that
theoretical channel seems more realistic than what was actually reported. The
earnings crash suggests to me that deceptive accounting practices are mostly
behind us, but the bulge probably means that there is an enormous amount of
fraud yet to be uncovered.
I have also drawn a black dotted line between the point of the 1997 reality
disconnect to the point where the S&P 500 ought to be if it were priced at fair
value. This is my estimate of the approximate path that prices would have
logically followed if a mania fueled by accounting deceptions had not
materialized instead. As you can see, it takes the S&P 500 from being
overvalued at 800 to fairly valued at 400 -- a painful -50% correction, but at
least most of the damage would now be behind us. Unfortunately, the price
bubble is not yet deflated, and it will take a decline of over -60% from
current levels (approximately 1000 on the S&P) to reach where we estimate fair
value to be. Yes, it is possible for earnings to increase to partially
alleviate the disparity, but this is not typically what happens. What has often
happened is that prices correct all the way to the undervalued level or lower.
I know you don't want to think about that, but that is a definite possibility.
NOTE: These charts were constructed using P/E values based on "as reported"
earnings, which are derived using GAAP (Generally Accepted Accounting
Principals), not "operating" or "core" earnings, which ignore certain expenses
in order to artificially boost earnings. The latter have no relationship
whatever to real accounting, yet they are are being widely used by the
investment industry in a effort to obscure the fact that the market by
historical GAAP standards is outrageously overvalued. Virtually all discussions
of earnings in the media refer to operating earnings as if there were some
historical context in which they can be placed; however, there is no
relationship whatsoever between operating earnings and the P/E ranges shown on
these charts
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