S&P 500 Earnings: 'The Pain of Mean Reversion'

The stock market has dropped. Corporate profits have collapsed, and profit margins have reverted toward the mean. So, what is next?

Before I dive into the discussion, let me explain the chart below, which I named appropriately, “The pain of mean reversion.”

I looked at reported earnings for S&P 500 and compared them to the “average case” earnings scenario. In the “average case” scenario, I took reported earnings of S&P 500 in the early 1990s and grew them at 6% - an average growth rate of GDP over the last century, which happens to be the same as earnings growth for stocks during the same century.

If the economy had no cyclicality and profit margins remained constant, you would see nice, steady growth earnings for S&P 500 stocks like the one in the chart.

Of course, profit margins do not stay constant - they fluctuate, thus actual earnings swing above and below the steady 6% trend line.

Click here for larger chart.

How far will earnings drop?

You’ll never go wrong quoting Mark Twain when he said, “History doesn’t repeat itself, but it does rhyme.” Our challenge as investors is to look at the past and figure out how history will rhyme with the future.

If you were to look at the recent history of the 2001 recession, earnings dropped 54% from their highs to their lows. If S&P 500 reported earnings were to drop by the same amount this time around, they would be at about $39. We are already below that level, 2008 estimates for S&P 500 were revised down again, now to $28. However, this is where Twain’s rhyming thinking becomes important - note that in 2001 earnings went only 18% above the “average case” line, while in 2007, they were 31% above that line. If we were to follow the higher they climb the harder (deeper) they fall logic, this would lead us to believe that earnings will drop further this time, estimates for early 2009 earnings indicate that.

When will we see average earnings?

The good news is S&P “average case” earnings are about high $70s to low $80s a share (see big red squares in yellow shaded area) - which would make the market cheap (with a PE of about 10). However, here is the bad news (don’t shoot the messenger please) - we just won’t see those “average case” numbers for a while.

The 2001 recession was driven by the overcapacity in the corporate sector. Corporations rationalized their inventories and factories, higher unemployment followed - we were in a recession. Excesses were worked out, corporations started to hire, and voila - we were out of the recession. Of course the recovery process was also aided by a “friendly” Fed, it took interest rates to (at the time) an unprecedented low levels and kept them there until corporations and consumers got seriously drunk on cheap money and spent themselves into serious debt for which we are paying now.

In the 2001 recession, it took two and a half years for earnings to rise from their bottom to their average.

Unfortunately, we’ll not be that lucky this time - we are in a consumer recession. Consumers are two thirds of the economy and they are deleveraging. As a side note: This deleveraging goes beyond big-ticket discretionary items like large screen TVs and SUVs. Now it is showing up in lower consumption of staples like iced tea by Snapple, which competes, with cheapest commodity of all - tap water. Now, the more expensive branded products like diapers and tissue made by Kimberly Clark are forced to compete with generic store brands. The meaning of the word staple is being redefined by this economy.

The Fed, being even “friendlier” than the last time, has lowered interest rates to almost zero, buying long-term bonds, etc. But this time around the Fed’s booze will not do the trick - consumers are still suffering a hangover from the last Fed’s “help” - they don’t want to borrow and banks, after incurring huge losses, are behaving like real banks - only giving loans to people who’ll pay them back.

In addition to consumer deleveraging, government debt is skyrocketing with every bailout, thus taxes and interest rates are likely to be significantly higher once the economy normalizes.

The earnings recovery will likely take longer than many expect, therefore, there is a very high possibility that going forward, the “average case” earnings growth would be below the historical average of 6%.

Are we about to embark on a secular bull market?

The market is a discounting mechanism - stocks will rise in the anticipation of a future earnings rebound, before the rebound. Similar to the stock market forecasting ten out of the last three recessions, it will discount a few recoveries before the real one takes hold.

What does this mean? We’ll likely have a few “fake” head starts and disappointments before the actual earnings recovery takes place.

As I argued in my book Active Value Investing: Making Money in Range-Bound Markets, we are very likely in the midst of a secular range-bound (trendless, volatile but going nowhere) market that started in early 2000. Historically, range-bound markets started at the end of the secular bull market when P/Es were above average. They ended when P/Es stopped declining (mean reverting), after a visit to below average territory (around 10-11 or less). The current range-bound market started at much above average valuation and will likely rhyme with the past finish at below average valuation as well.

Based on the ‘pain of mean reversion’ chart we are trading somewhere between 30 and 10 times earnings. However, neither number is very meaningful. Let me explain:

• 2008 estimates of $28, the “E” in P/E of 30, are distorted by massive charge offs.
• The “average case,” the “E” ($80) that went into P/E of 10, lies in a far away land that … well, let me put it this way, you and I will get to grow sick of presidential campaign advertisements at least once or maybe even twice before that “E” is in sight.
• Even based on 2010 “E” estimates ($40) stocks in the S&P 500 are trading at 21 times earnings.

Despite the decline, the market is still not cheap. Sorry, we are not likely to embark onto the new, secular bull market anytime soon. History and data suggest that the choppy markets that we have seen since 2000 will likely continue. Owning a broad market index will not pave a road to prosperity. It comes down to not just owning stocks but owning the right stocks.

(P.S. As a side note I believe significant earnings write-offs will continue well into next year as financial stocks will pass their write-off torch to companies in energy, materials and industrial sectors - stuff stocks - that will be writing off the investments they’ve made over the last five years.

By the time, I finished putting these thoughts together, (which on and off, took about two weeks), 2008, 2009 and 2010 estimates were taken down by about 20-25%.)

Comments

[morph366:]

Very interesting piece. One of the smartest remarks in your article is "The meaning of the word staple is being redefined by this economy."

Feb 19 10:20 AM

[Alphameister:]

All too persuasive, I'm afraid. And you didn't even mention the reality that the current political powers in DC are determined to redistribute wealth and income from shareholders to a vastly less productive segment of society.

Feb 19 10:50 AM

[CautiousInv...:]

Nice article.

I would like to add that the effective corporate tax rate has declined over the last 15 years and you can be sure this will be addressed as part of a panic to find ways to help offset massive budget deficits.

And two, if the consumer delevers their balance sheets from 120% debt to income to 100% debt to income, it will suck $1.6 trillion out of the economy through increased savings and debt liquidation.

Corporations will also delever and studies show this will produce further headwinds for improving profit margins and ROI.

Feb 19 10:59 AM

[da'zman:]

What isn't much talked about these days is the 'cooking' of headline earnings numbers with accounting tricks. Typical example being 'one off charges' for a discontinued business. Companies will mark down and sell of inventory and instead of the margin compression that results in, says that they are out of that business and instead takes a charge. S&P at 600 sounds fair at this point.

Feb 19 11:39 AM

[Larrysyr:]

Thanks for this analysis.

If I read the chart correctly, The S&P 500 would trade at 10 times P/E on the long-term (red) line somewhere a little below 800. Which is where it has rested the past few days.

I'm curious - Has the market simply priced in an expectation that things will return to normal in the next couple of years?

Feb 19 12:06 PM

[Moon Kil Woong:]

The vaporization of equity, goodwill, real estate, etc. is already taking place. The consumer is already deleveraging. Corporations are already pulling back. All as they should. It is normal in a cyclical downturn. The only one encouraging people, banks, and companies to stay overextended is the government for its own self interest.

Deleveraging is fine as long as it ends in a timely fashion. Prolonging the downturn only risks a persistent downturn and the doldums that ensue from a multi-year down cycle.

Feb 19 12:11 PM

[TomF75:]

Couldn't agree more...think about it, deflation is good for the saver, dreadful for the borrower. Since our government hasn't been a saver for 20-30 years, they will do whatever they can to induce inflation for their own self interest...regardless of whether that is good for you or I.


On Feb 19 12:11 PM constructe wrote:

> The vaporization of equity, goodwill, real estate, etc. is already
> taking place. The consumer is already deleveraging. Corporations
> are already pulling back. All as they should. It is normal in a cyclical
> downturn. The only one encouraging people, banks, and companies to
> stay overextended is the government for its own self interest. <br/>
>
> Deleveraging is fine as long as it ends in a timely fashion. Prolonging
> the downturn only risks a persistent downturn and the doldums that
> ensue from a multi-year down cycle.

Feb 19 12:39 PM

[Socialism c...:]

Which does NOTHING to encourage those who have money to spend it! It only encourages further hoarding, to try to recoup ones losses from government pillaging!


On Feb 19 10:50 AM Alphameister wrote:

> All too persuasive, I'm afraid. And you didn't even mention the
> reality that the current political powers in DC are determined to
> redistribute wealth and income from shareholders to a vastly less
> productive segment of society.

Feb 19 01:08 PM

[gjvoor1:]

nice article - any guess on the ultimate bottom?

Feb 19 02:05 PM

[Jason Laurent:]

Great article. Also, interesting to see that there's a nice support line going through the lows of early 90s and early 2000 which is intersecting where we're at today. A possible bottom?

Feb 19 02:44 PM

[dlaw:]

The rough thing about this piece is that it is very good, quite negative and wildly, naively optimistic all at the same time.

Ouch.

Feb 19 03:19 PM

[Jason Rines...:]

I liked it. I have been thinking about what the medium mean really is. Is it 1998 or 1993? Deleveraging debt is one thing, what about inflation relation abnormalities created through banking or government policy manipulations?

Feb 19 04:03 PM

[Alex Trias:]

Very useful article, although I'm not sure your conclusions follow from the evidence you cite. Looking strictly at the law of averages (and you shouldn't), you'd conclude earnings growth would rebound quite a bit faster than four or eight years from now.

Also, and not to quibble, but PE ratios can be very much higher than average at the end of a bear market - as we saw in 2003. Demand for stock (which is all that a PE ratio measures) is driven by human emotion, available alternative assets producing relatively favorable returns, and does not correspond to any statistical laws I am aware of.

The case for a long flat market is certainly there, but I'd cite historical evidence - like the period following the last secular bull market that ended in 1965. A 15 year flat stretch followed, which seems to be roughly the case you're outlining. The 1970s would be a great area for you to cite in your article. On the other hand, I would also look closely at the crash of 1929 and the period in throughout most of the 1930s, which was not characterized by a protracted flatline market, but a stunning "V" shaped decline followed by the largest secular bull market in history - which really got cooking as the nation plunged into a seemingly bottomless depression.

There is a good case to be made that the globe will experience something like the Great Depression this time around, as well. If so, and if past experience is any history, equities markets may rally by hundreds of percents throughout the downturn.

Problem is, if that's the correct historical scenario, we won's see that bull market until the Dow Jones hits 1,500 or 2,000, which would happen sometime in 2011.

The problem with history is that it's not consistent, and as Yogi Berra said, the future is always changing.

My solution: invest according to the human condition, rather than the law of averages.

Feb 19 05:59 PM

[sether:]

How are shareholders productive?


On Feb 19 10:50 AM Alphameister wrote:

> All too persuasive, I'm afraid. And you didn't even mention the reality
> that the current political powers in DC are determined to redistribute
> wealth and income from shareholders to a vastly less productive segment
> of society.

Feb 19 11:34 PM

[nmelendez:]

If you look up the P/E on the S&P last September, before the fall, it was at 24. After the fall, at S&P 732, the P/E was at 12.5. The median for the S&P is 15. However, if you look at the median from the last 20 years it,s at 20. In 2006 the P/E was at 17. Now the bubble burst. Personally i do not see this market going down below 600. My view is we are due for a false rebound and fall, So now i tipped in at 30%, effective tomorrow at 6:00 PM.

www2.standardandpoors....

Feb 20 12:17 AM

[Chris B:]

The recent volatility in earnings and share prices demonstrates the basic business truth that stocks are just claims to net earnings, which are the leftovers, if any, after accounts payable, taxes, bonds, preferred dividends, etc. are paid. These leftovers can vary widely, and thus so can share prices.

The bottom line is if you can't handle 10 more years of this type of volatility, you should find another investment vehicle.

What really saddens me is to see 60 year olds gambling 80% of their retirement portfolios on the theory that their talents allow them to earn constant, positive, double-digit returns (even thought the long run difference between stock and bond performance is something like 2%). It's also sad to see people in their 20's gambling their savings trying to make a quick buck instead of using those funds to go to college.

Each of these investors is a prime candidate for selling at the bottom and buying at the top.

The price of hubris is poverty.

Feb 20 04:02 PM