Morningstar analyst, Samuel Lee, describes one of the major challenges facing those investors who look to base their decisions on valuations. Lee says, that “the problem is that earnings quality–operating, and as-reported, has declined over time.” He cites Warren Buffet on the topic from one of his shareholder letters:
It was once relatively easy to tell the good guys in accounting from the bad: The late 1960s, for example, brought on an orgy of what one charlatan dubbed ‘bold, imaginative accounting’ (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America’s most-admired companies then shunned deception.”In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers–CEOs you would be happy to have as spouses for your children or as trustees under your will–have come to the view that it’s okay to manipulate earnings to satisfy what they believe are Wall Street’s desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.
Lee’s article brings up the question of whether P/E ratios should be compared to their 130-year average or whether it would be better to compare today’s P/E ratios to their 30 or 50-year averages in order to determine whether the broad U.S. equity market is overvalued or undervalued.
Such difficulties with valuation only strengthen the case for trend following. It’s not that earnings don’t matter–they certainly do. It’s just not clear in what time frame and to what degree they will impact the stock price. Investors are free to use any criteria they choose (or none at all) to determine whether they will buy or sell a given stock, ETF, or mutual fund. Trend followers, like us, spend much less time worrying about concepts like overvalued or undervalued and much more time focusing on executing a strategy that seeks to build a portfolio of securities that have favorable relative strength characteristics. Over time, we generally end up with a portfolio of securities that many analysts would view as fundamentally strong (at least in retrospect), it’s just that we rely on “the wisdom of the crowds” instead of Wall Street earnings reports.
HT: Abnormal Returns