When the stock market gets on a roll such as we’ve seen over the past month, it is very easy to forget about the fundamentals and just assume that the current romp will go on indefinitely. After all, through Friday March 5th, the Dow is up+6.6% from the February 8th low, the S&P has gained +7.8%, the NASDAQ has moved up an impressive +9.4%, and the Russell 2000 has exploded higher by +13.6%. Thus, it is easy to succumb to the bullish thesis being bandied about on a daily basis and to become fearful about missing out on a monster move.

We do believe that stocks are likely to move higher over the next couple of months in response to an improving economic environment and the relief that the Greece situation won’t usher in “Credit Crisis II: The PIGI’S Squeal.” However, we also need to keep in mind that the good old days have not suddenly returned and that this is unlikely to be the type of one-way market we saw in the 1990’s.

To review, we’ve tried to make our position clear over the past year that we’re dealing with a secular bear market here in the United States (meaning an extended period – think 10-15 years – of negative/subpar returns) and that the current “mini bull” is not likely to be a multi-year affair.

As we’ve laid out, our macro view of the stock market is that this remains a buy-and-sell type of market such as we saw during the 1965 – 1982 period. We have no idea where the upside of the current mini bull is, but we doubt that Dow 14,000 is going to be achieved anytime soon. And wherever the top from the current mini bull, which began almost a year ago, may be, we need to recognize that managing risk is likely to be the key ingredient to investment success during this secular bear phase.

There are three primary reasons behind this view: The debt bubble; The generational change in consumer behavior; and The return of “real” earnings. We’ve talked about the first two extensively over the past year. So this weekend, we’ll take a look at the subject of earnings and how Wall Street has come to distort what a company “really” earns.

To hear the bulls tell it, the S&P 500 should earn something on the order of $75(ish) in 2010. Thus, if you apply a multiple of between 17x and 20x, it would appear that stocks have an awful lot of upside and it’s time to “Party on, Wayne.” The bulls suggest that the S&P could wind up at around 1500 by year-end using this approach, which means a gain on the year of about 35%. Party on, indeed.

While there are several flaws in this thinking, we’re going to restrict our analysis this weekend to the issue of the earnings and how they are calculated.

Before the tech bubble forced analysts to create new ways to calculate valuations, earnings were earnings. In other words, companies tended to follow the GAAP (Generally Accepted Accounting Principles) guidelines when they reported earnings per share. But as the great bull market of the 1990’s progressed, it became harder and harder for companies to show growth in GAAP terms, so the idea of “operating earnings” became popular.

In short, operating earnings are supposed to eliminate one-time or special items from the earnings calculation. The idea here is to smooth out the earnings numbers and eliminate the impact of big expenses/gains that are unlikely to be recurring. But as time went on, the financial engineers began to expand their view of one-time items and basically threw out anything that didn’t look good.

According to Ned Davis of Ned Davis Research, operating earnings have turned into financially engineered results which utilize only the “good stuff.” And in Ned’s words, operating earnings wind up being whatever the company says they are – i.e. they are not actual earnings.

For 2010, Operating earnings are projected to be $70.86 for the S&P 500 for the year ended 9/30. If you put a 17x multiple on that, you get 1204. And if you go with at 20x multiple, you get 1417. Thus, with the S&P 500 currently sitting at 1139, it is easy to argue that stocks have some upside.

The problem is that according to NDR, projected GAAP earnings for the same time period are only $55.85. Thus, a 17x multiple projects the S&P to trade at 950 while a 20x multiple puts it at 1117. So, with the S&P at 1139 currently, one could argue stocks are overvalued.

However, if you throw out all the financial tricks and take the idea of earnings down to what Warren Buffett calls “owner’s earnings” the picture is very different.

As a value investor, it is a safe bet that Warren Buffett knows a thing or two about earnings. And as someone who likes to keep things simple, Buffett’s view of earnings boils down to cash flows that can be delivered to investors as dividends or retained by the company for future use. (The actual definition is: “cash flows that will be delivered to investors as dividends ore retained on their behalf as an increment to the book value of the company.”)

The problem here is that these so-called “owner’s earnings,” which, we will admit are subject to interpretation, are well below both GAAP and Operating Earnings. NDR went back to 1970 and calculated the 5-year average of all three approaches to earnings. The 5-year average of Operating Earnings for the S&P 500 is currently around $84; GAAP earnings are about $57; and “Owner’s Earnings” are in the vicinity of $36.

We are not suggesting that “Owner’s Earnings” are the best way to look at the market from a valuation standpoint. And we are not saying that Wall Street should shift back to GAAP earnings. No, we’re simply pointing out that you need to use a very rosy (and not terribly accurate) view of Operating Earnings in order to justify a lot of upside in the stock market.

However, let’s keep in mind that this type of macro thinking has little-to-no use on a short-term basis and that the market can and usually does do whatever it darn well pleases. The point here is if something occurs that would cause investors to question the validity of earnings, the bears might have a case.

All the best for a profitable week,

David D. Moenning
President, Heritage Capital Management
Home Office: 630-250-4700
Direct: 303-670-9761