The average of all reported earnings from December 1997 through December 2007 is 42% below the 2007 Q2 peak and 28% below the long-term trend line. Figure 5 graphs a correction in earnings down to the S&P 500’s normalized earnings level. The oscillation of reported earnings from the 2007 earnings peak now looks more like prior corrections. Notice that the resulting price-to-earnings ratio (P/E) is the same (14) in Figures 4 and 5. However, the price for the S&P in Figure 5 is 27% lower than it is in Figure 4 because lower stock prices need to compensate for a weaker "E" in the P/E. A P/E estimate of 14 is conservative because the average P/E near market bottoms after P/Es have exceeded 20 is a little more than 9. A P/E of 9 implies an S&P price near 450 and a -71% price decline from the market’s all-time high.
A P/E of 9 is not likely because the Federal Reserve is doing everything possible to inflate our way out of a credit crisis. They will most likely continue to pump $30 billion to $50 billion per month into our financial systems until the banks are relieved of their constraints on capital. Under these circumstances, P/Es near 15.8 seem more likely than 9. These assumptions result in a bottom for the S&P 500 somewhere in the range of 972 to 1152.
Figure 6 applies various S&P earnings levels assuming a constant P/E of 15.8 (the market’s average P/E since 1940). Doing so provides S&P price levels 40% lower to 19% higher than the index’s Feb-08 closing price. Notice that with an associated P/E of 15.8, the S&P’s Oct-07 price peak was within 0.22% of its potential under current 2008 operating estimates (these S&P estimates are too high).
A 20% contraction in earnings ($67.90) is close to the average seen during recessions since 1960. Increased economic globalization will not prevent a recession. However, globalization and Fed pumping will most likely mitigate losses. My estimates are very far from the worst-case scenario. Most investors do not view declines of 19% below last month’s close and 31% below the autumn high as moderate estimates, yet they are!
Investors often cite low 10-year Treasury Note yields, which hovered near 3.75% for much of Feb-08 as supportive of higher stock prices. They cite earnings yield (EY) ratios of 1.98, 1.44 and 1.30, which result from dividing operating, normalized and reported EYs by the T-Note yield, as evidence that stocks are undervalued relative to bonds. Stocks might be better values than T-Notes over time horizons greater than three years, but high ratios did not indicate a bottom for stocks in 2001, and they may not now. Note yields declined from 6.7% to near 3.3% from January 2001 through June 2003 and so did stock prices. These ratios do not call bottoms when default risk is greater than inflation risk, which has been the case since July 1997. Figures 11-12 demonstrate the positive correlation between the Federal Funds Rate (and Note yields) and equity returns. Lower rates do not support stocks when investors fear a return of principal more than a real return on their principal.
Figures 4 and 5 reference LQ and HQ. These acronyms stand for low- and high-quality stocks in relation to a low and high consistency of historic earnings and dividend growth. LQ stocks lead the market when earnings growth rises above its trend line, and HQ leads after earnings peak and then correct to a trough. With current earnings near $72 and a reasonable risk that earnings might drop to $50, investors should overweight their portfolios to blue chip stocks within stable sectors of the market. They should then wait for an optimum time to add LQ issues to their portfolios. For a few LQ stocks, the time to buy is here or near (Figures 9-10). Individual security selection is for fund managers or investors with the time and talent.
Price Continues To Speak
It is time to recap past technical observations and estimates of market direction made in our November 2007 installment titled Defense Pays. Figures 7-15 are updated charts that capture some of the primary views expressed in past installments.
Technical analysis has seldom worked better than it has since July 2007. Uncertainty over hidden credit losses, fear of a cyclical earnings peak and a subsequent recession have created a technically driven market. This is what markets do when investors get too greedy or too fearful. The market tells us where prices should be. Figure 8 shows we were listening. The line and circle represent estimated target prices for large- (OEF) and small-company (IWM) stocks made in November 2007, which were spot-on.
Market prices are not knowable by the masses at extremes. Hysteria is manic-depressive. Prices must be rediscovered to adjust for risk premiums that were too low (1999 and 2007) or too high (1990 and 2002). Excessive greed and speculation in the credit markets drove the 2007 market out of bounds. A maddening crowd priced credit as they roared for more! Usually credit markets are the tail that wags the dog (equity markets); however, credit risk was so mispriced from 2006 to July 2007 that the Devil (credit) possessed the dog (equity markets). The credit market is many times larger than the equity markets, so the dog has and still has a lot to swallow.
An updated Figure 9 shows only 25% of all New York Stock exchange issues were priced above their 200-day moving price averages ($NYA200R). $NYA200R is in a buy zone (readings less than 25%) for investors willing to hunt through stocks to find bargains on issues that they can hold for at least five years. Get ready for some OFFENSE!
Bottom fishers should preserve bait for fish that swim in deeper waters. We have been watching $NYA200R since July 2007.