Bear Value, Fair Value, and Bull Value

I am an optimist, but I spend a lot of time on speculating on what pessimists might think. So far we have had major economic events which drove the markets downwards. We have had a significant rally off the lows and are in my view trading at a premium to fair values. Expectations are tending towards consensus of a subpar recovery, with significant risks to the downside. Most believe that we are in a cyclical bull within a secular bear market.

My own view is that we will have several years of subpar growth; but we have seen a generational low in the nominal index. Yet it is likely that we will see a lower low in the real index at the bottom of the next recession.

What would really surprise everyone is if the market went on to record new highs, and came in with a next cycle low, higher than the recent lows in both nominal and real terms. The market has a way of surprising everyone and since this outcome is the only one which would surprise all, it is something that needs to be contemplated. I told you I was an optimist!

Bear Value – 620, close enough to the 666 we saw

We saw SP500 dividends at the end of 2007 at $27.73. They had grown from $15.74 in 2001, which market the end of the prior recession. Dividends tend to be less volatile than earnings; the standard deviation between 2001 and 2007 came in at $4.61. With the severity of the crisis, a fall in dividend of one standard deviation is a reasonable expectation. A trough dividend of $23.12 was to be expected; but after that they could be expected to grow. The rate of growth I have assumed is 3.5% in real terms and 3.5% growth via inflation. An investor seeking a long term return of 11% for a dividend stream of 23.12 growing at 7% annually would be willing to invest 620.

A 3.5% global inflation expectation is not unreasonable with the amount of monetary stimulus which has been injected into the system. It is true that subsequent deleveraging will mean that the inflation is somewhat moderated, however, the pressure from global growth expectation in real terms of 4.9% annualized between 2009 and 2011 will act as an offsetting force. While post recovery growth expectations in the United States are expected to be subpar (2.2% to 2.8% range), the SP500 companies should benefit from globalization and participate in the higher real global growth rates of 4.9%; I do not see 3.5% real earnings and dividends growth as a challenging target.

Fair Value - 950

The six year average operating earnings at the end of 2009 is expected to be $71.32. To grow at a 3.5% real rate, no more than 50% of earnings would be required for re-investment. The remaining 50% is what I call a notional dividend. An investor seeking a long term return of 11% for a notional dividend stream of 35.66 growing at 7% annually would be willing to invest 950. Keep in mind that if a dividend is not paid, there is higher earnings growth coming from either reverse dilution due to share buybacks or from earnings growth from re-investment in profits; so it does not matter that the notional dividend is way in excess of the actual dividend.

Normal Value – 1,521

Most people do not invest at bear value or fair value as these events occur during periods when perceived risks are high. Most would invest at a premium to fair value and hope to gain as the market works up towards its normal valuation levels. The median 6 year PE between 1998 and 2009 ran at 21.3X 6 year average operating earnings. If the market trades at these levels during the next economic cycle, with an average 6 year earnings of $71.32, we could expect an index level of 1521. Using the bottom quartile 6 year PE between 1998 and 2009 would take us to an index level of 1,485.

Bull Value – 1,906

The top quartile 6 year PE between 1998 and 2009 ran at 26.73X 6 year average operating earnings. If the market trades at these levels during the next economic cycle, with an average 6 year earnings of $71.32, we could expect an index level of 1906.

Conclusion

The above normal and bull value levels assume that there shall be no growth in the 6 year average earnings over the course of the next economic cycle. As it happens, I expect the forward cycle 6 year earnings to come in at closer to 76. If this occurs, the forward cycle normal value would be 1,621. Using the bottom quartile 6 year PE between 1998 and 2009 would take us to an index level of 1,583. The forward cycle bull value would be 2,031.

In the cycle just concluded, the peak value of 1,566 was attained at median PE 6 levels; the multiples never did reach the bullish extremes of 26.73X at the top quartile. The peak was significantly lower in real terms compared with the prior cycle high. I can stretch my optimism only so far; I expect the next cycle to peak lower; the optimist in me looks for 1,485 at best; the realist in me is looking for 1,250-1,300. I speculate on a next cycle nominal low at 950; but that is too far ahead in time for now. And this is why it would not surprise me to see the market break 2000.

Other than the bull case, there is a firm belief that the recession has ended. Markets will be surprised if it has not and the market trades down again. So a new lower low is the other surprise the market might spring to shock the consensus. Like I said, I am an optimist and I do not expect this to occur; but hey, with markets, who knows what might happen in the short term.

Disclosure: None.

Comments

[Jason Tillberg]

One caveat to comparing the P/E in the 98' to 09' period is that we were in a tech boom where we went from 40% of households having internet and cell phones in 98' to 90% in 08'.

Of course P/E's will be high in those high growth years for tech stocks.

Mortgage debt went from $4.95 trillion in 99' to over $10 trillion by 07'. That kind of new debt was a boom to financials. They too enjoyed high P/Es for their growth.

I think the next 6 - 10 years, earnings overall will be anemic.

2009 Aug 27 09:45 AM

[Shiv Kapoor]

Quite correct. I think earnings will be anaemic (though perhaps not as bad as most expect) and multiples will contract. I am looking for median multiples of 16-18 with 20-22 at bullish extreames; this would be more consistent with the post 1978 period through 2009 - US might be slower but corporate US should gain from elevated global GDP growth.
I still think a major communication revolution will occur over the coming years, but the enhancement to earnings will come more from materials and energy which will offset weaker financial services and discretionary sectors. I think on IT, US has gone through its accelerated growth phase, but IT is affordable and there are absolutely huge growth prospects in emerging economies. I think the sector will be ready for a new growth spurt after a few more years spent in developing new markets.

On Aug 27 09:45 AM Jason Tillberg wrote:

> One caveat to comparing the P/E in the 98' to 09' period is that
> we were in a tech boom where we went from 40% of households having
> internet and cell phones in 98' to 90% in 08'.
>
> Of course P/E's will be high in those high growth years for tech
> stocks.
>
> Mortgage debt went from $4.95 trillion in 99' to over $10 trillion
> by 07'. That kind of new debt was a boom to financials. They too
> enjoyed high P/Es for their growth.
>
> I think the next 6 - 10 years, earnings overall will be anemic.

2009 Aug 27 10:09 AM

[Dave Wrixon]

You really are an optimist! I would expect to S&P below 620 this Fall.

2009 Aug 27 01:06 PM