Buy And Hold What?

June 24, 2009

The odds of a double-dip recession are growing. Emerging markets and corporate bonds appear vulnerable. But some areas look attractive.


We are more than half of the way through 2009. The year began with a failed stock rebound and a low-quality debt rally off the November 2008 lows. And despite a rally that started in March, troubling signs still remain.

The experience of past financially led, synchronized global recessions makes it likely that our recovery will be brief. Indications are that the current rebound will last no more than three quarters with a relapse into recession sometime after the second quarter of 2010.

Most troubling is the difficulty that we will have with exporting our way out of this recession after our government stimulus wanes. Our continued high dependence on the financial sector for growth, extreme consumer indebtedness and our low savings rate also enhance the odds of a double-dip recession (forming a W shape) similar to the pattern seen during the early 1980s.

Our scoring of the Chicago Fed National Activity Index and the Conference Board’s consumer confidence indicators are improving but remain in negative territory. The Institute for Supply Management Index also has improved to levels that indicate low but positive future economic growth. The Capital Economics Recovery Index (CERI) also has improved. CERI puts the odds at 1 in 3 that our recession will end before year-end 2009.

Where Is Value?

We have witnessed the greatest earnings crash in history. Recent operating earnings estimates are worthless, just as they were from 1998 to 2002. Last year’s estimates were near $81 for forward S&P earnings. They ended 2009 Q1 at $7.21 on a 12-month reported basis. The S&P 500’s reported earnings per share for the 12-month period ending in September 2009 has been estimated by Standard & Poor’s to be negative (at a loss of $2.09 EPS) for first time in the index’s history.




At its recent high near 950, the S&P 500 registered a trailing price-to-earnings ratio (P/E) of 132.

During times of de-leveraging, real gross domestic product growth usually ranges 1.5% to 2.5% for three to five years. At the same time, median P/Es revert to 12 and risk premiums fall to 4%. My estimates are for 12-month forward earnings on the upside at $55, at a median of $45 with a downside target at $30.

If these estimates are realized with the S&P 500 at a level of around 950, forward P/Es will be near 17, 21 and 27—which are rich when the S&P’s low dividend yields and lackluster earnings growth are factored into valuations.

Given the high degree of economic uncertainties—a high PIS (price index score), low visibility for earnings (with corporate annual default rates expected to be near 13% to 15% by 2010 Q2)—I’ve got to wonder what is worth buying and holding onto at this point.



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