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The Daily Reckoning | Monday, February 22, 2010 What to Make of Lofty P/E Ratios Following the Icarus Flight Plan Joel Bowman The Dow rose 11 points on Friday, or 0.11%. Binary code enthusiasts aside, that’s not much to get excited about, neither for bulls nor bears. In fact, the past couple of months have pretty much been a wash. Both the Dow and the broader S&P 500 sit more or less where they began the year. So, where to from here? Your editor has no idea where the markets will go...only an inkling of where they ought to go. And where they ought to go is back to the mean, as everything eventually does. Right now, the S&P goes for around 22-25 times earnings, considerably higher than the long-term mean, which Yale University’s Robert Shiller has at 16.35. Typically, investors do well to buy stocks when they are trading at between 5-10 times earnings. For instance, you could have bought the S&P for slightly less than 5 times earnings in the early 1920s. As we know, the index topped out later that decade, on Black Tuesday...when the P/E ratio hit 30. Provided you adhered to the mean reversion rule and sold before that fateful day, you could have bought the index back in ’32, again for around 6 times earnings. (It then rallied/bounced – to right around where it is now – before slipping back below 15 shortly after.) For the better part of the next seven decades, the S&P 500 flew cautiously under the 25-times-earnings radar, on a handful of occasions even ducking back below 10. It wasn’t until the easy money days of the mid-’90s that the index waxed up its wings and launched into the clear blue sky. For a while, it looked as though nothing could spoil the flight. Then, in December of 1999, at the lofty P/E height of 44.2, the wax started to melt. The rest, as they say, is very modern history. All this is not to say that the S&P is about to dive into the sea tomorrow. It’s more of a polite reminder to keep an eye on the altitude... Soaring deficits...sky-high debt burdens...lofty rhetoric... Staying with the Icarus metaphor for the moment...last week we sought the Daily Reckoning readership’s opinion on President Obama’s fiscal year 2011 budget. We wanted to know whether you thought it amounted to the “grand bargain” that, in January 2009, Obama said he wanted to achieve during his presidency. Does it, we wondered aloud, constitute a serious plan to reform federal spending programs and tax policies? Or has the man merely brought the nation’s finances close to the melting point? Here’s what a few of you had to say... Reader Ben J. wrote: “How can you endorse any budget that starts in the red and goes down from there? It’s insane at best, depraved at worst.” “I think President Obama is in a catch-22,” opined another reader, Bill S. “If he does the right thing and reigns in the scoundrels that benefitted from this mess and tries to get spending in check, he will be a one-term President. The only chance he has is to hope things turn around enough through the stimulus spending that people feel good when it comes to the voting booth to endorse him for another term. “I think when the majority of people who have worked hard and saved for their well being see what is or has happened to the buying power of their money, all current politicians will be in trouble. It looks to me like this trend has begun and some already see the handwriting on the wall and are not running for reelection. He needs to make decisions that most feel necessary and find a way to make us feel good about them. “Personally, I am and will be very reluctant to vote for any incumbent, for as far as I am concerned they are all in it for themselves first. They had the audacity to vote themselves fine raises and fine benefits and they let the rest of us to rot. Enough said.” “It’s possible that the Obama Administration thinks massive spending is a win-win,” added another reader, James. “If it works, he wins. If it fails, the economy collapses and the Federal Government takes over with emergency powers, he wins too. “They are not stupid. They are obsessed with power.” Reader Jim M. wrote: “To think what has been lost in our United States because of the basest of individuals elected to office, hired from the financial markets, whose seeming sole purpose was to make financial slaves of most American citizens. Congress is now held in such disdain by over 70% of the electorate, because they have been bought and paid for by big money. “There has not been one piece of legislation produced by our corrupt senators and representatives that hasn’t been tainted by a rotten stench. The whole lot needs to be replaced, from the White House to the Capitol Building. “[I] started working when I was 12,” Jim continues, “and at 70, I can say I do not know if I’ll ever be able to retire. But I grieve not for myself, but my grandchildren. I hear this from other grandparents every week. What a terrible shame.” And finally today, here’s what Rob N., a reader who may or may not have wished to provide us with a useful segue into today’s column, had to say: “I just recently finished David Walker’s Comeback America,” wrote Rob. “His assessment of the situation is very optimistic. All we have to do is: Raise taxes (political suicide), Overhaul the entire medical delivery system and stop escalating costs (impossible), Overhaul the entire education system (and stop escalating costs), Cut Medicare, Medicaid, Social Security and every other handout (political suicide), Overhaul the entire tax system (nearly impossible given partisan bickering), Gut the Pentagon and cut their expenditures (political suicide). “A politician that stands up and says, ‘We need to cut handouts and raise taxes, now elect me!’ wouldn’t even get a microphone. Our current political system simply cannot handle what needs to be done without causing major social unrest. We’re past the tipping point, in my opinion, simply because the above are not realistic to achieve before we have a major currency crisis which could trigger a worldwide fiat money supply crisis – given the reserve currency status of the dollar.” Thanks Rob, and to all the other fellow reckoners who wrote in with their opinions on where the country is heading. As for Mr. Walker’s musings, we’ve been featuring some excerpts from his aforementioned book as part of our mini-series on fiscal responsibility. You’ll find his latest below... The Daily Reckoning Presents The Trust Fund Con David Walker Social Security is in trouble. According to the Social Security Trustees Report, the Social Security program was in a $7.7 trillion hole as of January 1, 2009. That means Washington would have needed $7.7 trillion on that date, invested at prevailing rates, to deliver for the next seventy-five-years on the promises that the federal government has made. But we actually need much more than that to keep Social Security healthy, because it will experience larger and larger deficits both in the near future and beyond the seventy-five-year accounting horizon. As of January 1, 2009, that number – the amount we would need to invest to ensure the sustainability of the program for seventy-five years and beyond – was $15.1 trillion. How much of this huge sum do we have invested in real liquid and transferable assets today – that is, how much in actual money? Zero, zip, cero, nada, nothing! The truth is that the government’s Social Security guarantee is one huge unfunded promise. How can this be? I have mentioned the Social Security “trust funds,” where our payroll taxes go. All this money is transmitted to the federal government and credited to the Social Security trust funds. You would logically assume that these funds would have hard assets that have been saved and invested to cover the program’s future costs. However, rather than saving the money and investing it in a diversified pool of real and readily marketable assets, the government spends it and provides “special-issue” government securities in return. Just consider what actually goes into those funds. First there are the numbers reported in government financial statements. According to those numbers, Washington had issued approximately $2.4 trillion in special-issue US government securities that had been credited to the Social Security trust fund as of January 1, 2009. The computer records documenting these securities are held in a locked file cabinet in West Virginia. But there is a reason they are called special-issue securities, and it’s not good. Unlike regular government bonds, which people like us and the Chinese government can buy, these special-issue bonds cannot be sold; in other words, they are government IOUs that the government has issued to itself, to be paid back later – with interest. Imagine if you or I could sit around writing IOUs to ourselves that were worth something. Great way to make a living. Washington says that we can count on these bonds because they are backed by the full faith and credit of the United States government, which guarantees both principal and interest. But – believe it or not – under current federal accounting principles, the government does not consider these bonds to be liabilities – which is another way of saying the government doesn’t really think that it’s our money. Think about that for a minute. If you or I lend the government money by buying a bond, the government has to pay us back with interest. In other words, that bond is a government liability. But when it comes to the Social Security trust funds, the government is saying the special-issue securities it deposits are not a liability – in other words, they’re basically worth nothing at all. Now get this: The trust funds report these securities as assets on the annual reports that they provide to the public. Does that sound like wanting to have your cake and eat it too? Con artists of the world, I hope you’re taking notes. In my view, these bonds should be treated as liabilities, and their value should be counted as part of our debt-to-GDP ratio. After all, they are backed by the full faith and credit of the federal government, and I do not believe the federal government will default on them. Under the current scheme, the Social Security program has been running large surpluses since the reforms of 1983. But in actuality, Washington has spent those surpluses every year on other government activities. That is one way the government can reduce its public borrowing and keep interest rates down. To say the least, the federal government’s accounting for these funds understates both its total liabilities and its annual operating deficits. That brings us to another clever bit of Washington wordsmithing: the “unified deficit.” In public reporting, the government takes the real operating deficit, $638 billion in fiscal 2008, and subtracts the nonexistent amount credited to the Social Security trust funds, $183 billion in fiscal 2008. This “unified” figure – $455 billion – makes the federal budget deficit seem smaller than it actually is. And they have been doing this for many years. These accounting tricks would never be allowed in the real world, where trust funds are subject to stringent accounting rules and fiduciary standards. In essence, Washington is playing a massive con game – collecting your Social Security taxes, spending that money for its own purposes, and accounting for it in trust funds that are largely a fiction. A more proper description would be “trust-the-government funds.” Or as my boss, Pete Peterson, would say, “You can’t trust them, and they aren’t funded.” Just another example of how words used in Washington don’t have the same meaning they have in Webster’s dictionary. Don’t worry, the reforms of the 1980s are still keeping the system above water. Monthly benefits should be paid in full for at least another three decades. However, the Social Security program will begin to pay out more than it takes in much sooner than that. The retirement and survivors income program expects its payments to exceed its revenues in 2010 and 2011. That will happen because revenue has declined during the recession –while at the same time, more people are retiring. When the federal government has to start cashing in the special-issue securities in the trust funds in order to pay benefits, it will have to raise taxes, cut benefits, and/or sell real bonds to the public in order to raise real money for retirees receiving benefits. If the government issues more public debt – in part to attract more foreign investors – that will likely increase our foreign dependency. Regards, David Walker for The Daily Reckoning Joel’s Note: Readers may be interested to know that we recently confirmed Mr. Walker as a key speaker at this year’s Agora Financial Investment Symposium, to be held in Vancouver from July 20-23. If you haven’t done so already, make sure to reserve your spot at the conference. Tickets to our annual event are already selling fast and the early release discount won’t last long. Mr. Walker served as United States Comptroller General from 1998 to 2008 and is now the President and CEO of The Peter G. Peterson Foundation. He is also the author of Comeback America: Turning the Country Around and Restoring Fiscal Responsibility, from which the above essay is excerpted.