Anatomy Of A Value Trap

There is a widely held view among mainstream prognosticators that equity valuations are cheap. Their thesis is simple; the ongoing cyclical recovery will evolve into 2011 driven by the customary hand off from stimulus-induced demand to organic, self-sustaining economic growth. Accordingly, corporate America's operating leverage will transform that 3%-4% GDP growth into 15%-20% earnings growth. As a result forward P/E's of below 15 are cheap based on "historical" precedent.

There are serious flaws in this thinking. First, conventional wisdom says that a ~15 P/E is the correct historical average and therefore a forward P/E of say, 13 is cheap. But the historical context used in that analysis is typically the last 25 years or so, a period where massive tailwinds created a favorable environment for owning equities. Today's backdrop of regulatory uncertainty, heavy-handed government, emergency monetary policies, rising taxes, unfunded retirements, etc., is far more reminiscent of the 70's than modern intervals. Specifically, during the roughly ten-year span of political and economic uncertainty between Nixon's 1974 resignation and Regan's 1984 reelection, the S&P 500 sported an average P/E of approximately 9.6 and stayed in a range between roughly 7 and 13.5 for the entire period. After all, the P/E of the stock market is really just a barometer for the public's desire to own risky asset classes. So, much like the 70's, today's high degree of tumult probably warrants lower mean valuations.

Today's FDX earnings press release provides a perfect example of this. CEO Fred Smith describes a reasonably favorable economic backdrop over the recent quarter. But in the outlook section of the release he cites significant headwinds to the forward operating environment. "we expect the growth in earnings in fiscal 2011 to be constrained by significant increases in fixed pension expenses... along with higher anticipated health care costs." Thus, one of the premier franchises in America, sees structural constraints to its operating environment for the foreseeable future, all else equal. Hardly the kind of commentary that inspires investors to stick their necks out.

Moreover, the consensus economic view is also potentially flawed in that it employs a similar mean-reverting mentality. In reality, is 3%-4% real growth even possible when forward-looking CEO's are forced to play defense? To the degree that the looming second quarter earnings releases reveal a creeping macro-induced conservatism on the part of America's CEO's a'la Fred Smith, the market could be heading straight into a period of downward adjustment for expectations around not just earnings and growth but valuations as well.

A 13 forward P/E is only cheap if we're in a secular bull market. We're not.