David A. Hartman’s “Wall Street’s Turn” (Vital Signs, December 2002) accurately outlined several factors that drove the U.S. stock market to extreme valuations in the late 1990’s, and, as an equity portfolio manager, I found his insight to be both refreshing and a welcome respite from the utter nonsense of the mountebanks at the brokerage firms with whom I deal on a daily basis. However, I would like to take issue with Mr. Hartman’s claim that the “most obvious misinformation that brokers propagated” was in switch-ing from valuing stocks on P/E ratios based on reported earnings to P/E ratios based on forecast earnings. According to finance theory, the current price of a stock is the sum of its future discounted dividends. (In the case of stocks that do not pay dividends, the theory supposes that every business enterprise will eventually run out of new investment opportunities and the excess cash thereby generated will be returned to the shareholders to invest.) In order to calculate the expected dividend stream, analysts estimate a company’s future earnings and apply an appropriate dividend payout ratio. Having made these projections using such financial statistics as earnings trends, asset values, and cash flow—all of which Mr. Hartman cited as relevant data—the investor compares the stock’s current market price to his expected future earnings per share. By comparing the resulting P/E ratio on forecast earnings to the stock’s own historical P/E valuation range, the P/E ratio of similar companies, and the P/E ratio of the market overall, the investor then has a base (but far from the only base necessary) to evaluate whether to purchase or sell. Conservative investors will also look at the stock’s price as a percentage of the company’s net worth (the price-to-book ratio) as well as its dividend yield, to name just two other basic valuation parameters.
Rarely do professional investors focus on the P/E ratio based on reported earnings, since the stock market is an efficient market—though, admittedly, the degree of efficiency is arguable. If we accept that the stock market is even minimally efficient (meaning that all relevant and ascertainable information is already reflected in stock prices), then evaluating stocks on the basis of their P/E ratio based on reported earnings is like driving a car while using the rearview mirror to steer. Hence, investors and analysts build models to calculate what a firm might earn in the future, something that the market may not yet have incorporated into a stock’s price. The real problem with the P/E ratio based on forward earnings was the ludicrous projections from the investment banks’ carny barkers (a.k.a. equity analysts) and their cheerleaders on MSNBC and CNBC and all the other complicit media lackeys who transformed the stock market of the late 90’s into a giant casino with nary an Indian reservation in sight. Ultimately, each investor is responsible for knowing what he pays for a stock in terms of its valuation—the P/E ratio on whichever basis he prefers, depending on his belief in market efficiency, price-to-book ratio, dividend yield, etc. If amateur investors had spent as much time doing simple equity analysis as they did reading TV Guide, then many of the investment horror stories in the press today would have been, at the very least, not quite so bad. Caveat emptor.
—Mark G. Brennan
New York, NY
Mr. Hartman Replies:
Mr. Brennan’s defense of investment based on rosy forecasts of earnings reminds me of the sad story of the divorcée whose physician was amazed to find that she was still chaste. She explained that her former husband was a liberal politician: “All he did was sit on the bed and tell me how great it was going to be.”
My complaint with the huckstering of securities concerns the substitution of similarly rosy forecasts for the information necessary to making an informed decision on an investment’s current circumstances, future prospects, and intrinsic value. I provided a list of the relevant data required to make such an assessment, not just P/E ratios.
Of particular concern was the shameless reporting of forecast P/E ratios in place of historical P/E ratios without ever drawing investors’ attention to the sleight of hand. Mr. Brennan fails to address the subsequent escalation of such mirages with the substitution of P/E ratios based on EBITD—earnings before interest, income taxes, and depreciation.
Of course, the phony accounting and reporting of corporate earnings contributed to the phony forecasts. But this does not explain continual forecasts of soaring earnings during the past four years of stagnant or declining actual earnings. Without relevant historical information, misinformed investors continued to support Wall Street’s cheery forecasts with their hard-earned savings.
As Mr. Brennan notes, both the forecast of earnings and the appraisal of analysts’ forecasts require the scrutiny of the trends of historical data, thus confirming my contention that investors denied historical data were denied full disclosure.
Alas, given unreliable prognostications, both the unfortunate divorcée and Wall Street investors fell for a line of “bull.” Ironically, however, it was they, not she, who were “taken to the bull.”
On the Family
It is about time that a conservative magazine criticized the 1950’s-style family (Nuclear Family Fission, November 2002). Chronicles seems to be the only one that has understood that the problems with our culture did not start with the cultural revolution of the 1960’s. The 60’s revolution came after the 50’s because there was something wrong with the 50’s that needed to be addressed. Of course, the solution was worse than the problem. Nevertheless, the nuclear family was never meant to carry the weight put on it by the flight to suburbia and grandma’s flight to Florida. An extended family is needed to rear children properly—grandparents infuse traditions that the parents have yet to adopt fully, and aunts, uncles, and cousins also help to round out the family and fill in holes. Although it may not be the norm, there are plenty of children who have had a special aunt or uncle who understood them better than their parents did and played a significant role in helping them to understand their place in this world.
I would like to see more analysis on what we need to do to get back to a world where children are reared in a community—a true community where most everyone knows everyone else; where, if a stranger comes into town, it would be appropriate to ask him what his business is in these parts; where it would be inconceivable for a sniper to drive into town without anyone knowing, shoot someone, and then just drive away.
The various authors in your November issue have come to some conclusions about recreating community, ranging from turning off the TV (preventing the mass culture from taking over your local culture) to refusing to take a job in a place too far from home. These are very good suggestions, but what can you do when you have exhausted all your savings looking for 18 months for a job in the area in which the grandparents of your children live? When a job is offered to you from across the country, can you afford to reject it? Or, equally bad, even if you are able to remain in your community, what can you do when many of your family members and friends move out for better job opportunities? Or, worse, what do you do when all of your extended family seem to have the habit of turning on the boob tube every evening? One person does not a community make.
Furthermore, how do you address the rich man who says that community is just an insurance policy for the poor? These elites have left their communities to live in isolation in fancy suburbs so they do not have to take care of others and have others meddling in their business. They say that community is overvalued and complain about the more negative sides of it—people in need asking to borrow money and others sticking their noses in their business. Many of them do not care about paying 40 percent of their income in taxes, because the other 60 percent is sufficiently large for them to satisfy all of their wants. They would rather not be bothered than pay much less and have to focus on the needs of others. They say that they have more important matters to attend to; they work 60 hours or more each week and do not have time for community. They have sufficient funds to fly their immediate family home for the holidays and sufficient time to focus on their nuclear family, but that is all. Would these people actually benefit from community? How can we convince them? They enjoy being philanthropic, as long as that means going to expensive black-tie events and mixing with others who are wealthy. Getting involved with someone truly in need—that is a different story. If we cannot convince the rich that they need community, then community may be gone for good as a societal norm.