March 3, 2017

On Friday, the S&P 500 was about unchanged while Toronto rose 0.5%.

Costco fell 4.3% to $170.26 after announcing it would increase its annual membership fees. Costco is a wonderful comp[any but the stock has seemed too expensive. I don’t think this fee increase is ANY reason for the stock to drop. But I think it probably deserved to drop just because it was too high.

I trimmed my very large position in Toll Brothers today selling what amounted to 29% of my shares. But I still have a very large exposure to this company. I also sold one third of My American Express shares and about 35% of my Bank of America shares. This was to raise my cash position from 20% to something closer to 30% given the high valuation of, in particular, the S&P 500. In all these cases I had profits on these shares and I was selling in registered accounts where I would generate no income tax. I have no actual fixed income and so my target 30% cash still leaves me with a 70% exposure to equities.

In my updated analysis posted yesterday I documented that the S&P 500 has a trailing P/E ratio of 25.

I checked ishares today and they see the P/E ratio as a bit over 21 by simply ignoring all negative earnings.A case can be made that if you had, for example 9 companies earning a dollar and one losing a dollar, for a net of $8 you could close the loser and still be making $9 and so in that view it is proper to ignore the negative one. But the reality of the S&P 500 is, I think, more like owning ten companies where every year one will lose money but you don’t know which one, it will be a different one every year. On that basis I just can’t see ignoring negative earnings. In any case a P/E of 21 is also getting expensive.

I saw an analyst on CNBC say repeatedly today that the P/E on the S&P 500 is 17. Well, that is based on the summation of the forward earnings forecasts of all the individual companies. (And even on that basis the correct figure is 18.2.) These forecasts are notoriously biased high. Every year some of the S&P 500 companies will have losses that come as a surprise to the market. These forward earnings forecasts simply will never pick that up in the forecast. Each analyst covering each company will tend to forecast that his or her particular company will grow earnings. Rarely will any analyst forecast a decline. Yet in reality a good chunk of the S&P 500 companies will fail to grow earnings in any given year. We don’t know in advance which will be the laggards. But I can’t see using an earnings forecast that ignores the reality that there will be laggards and surprises losses. I think anyone saying that the S&P 500 P/E ratio is 17 should be obligated to explain that is on a forecast basis. S&P used to provide a lower earnings ¬†forecast (higher P/E) by asking analysts to give a forecast for the overall S&P 500 earnings. They discontinued giving that less optimistic number saying that not enough analysts were willing to forecast it.

I am not forecasting that the S&P 500 will drop. It might, it might not. But as it rises the whole investment community is basically inclined to find a way to explain how it is not over-valued. By using very optimistic earnings projections, voila, the index is not overvalued and the party can continue.

So far the market has continued to shrug off the fact that the FED is likely to raise interest rates this month and to shrug off any potential bad news that might come out of the White House investigation into Russian contacts during the election. Perhaps both are nothing to worry about. We shall see.