Picking up where I left off in the last post regarding forward earnings, David Rosenberg has this to say:
Intel (INTC) enjoyed its best quarter ever at the peak of the inventory cycle. Well done.
What we are grappling with is this. If the consensus earnings forecast is “the market”, then the S&P 500 is de facto pricing in $96 of operating earnings next year — a new peak. Now that is a 35% increase from here and it is extremely difficult to see profits soaring that much at a time when margins are already back at cycle highs and with the prospect of slowing nominal GDP growth. It just does not add up.
Well, one can always say that even if earnings come in at $80 in 2011, what’s the guff? Slap on a 15x multiple and you still get to 1,200 on the S&P 500.
Of course that 15x is what the bulls use because periods of “low inflation” deserve a higher multiple. Well, that may have been true in periods of supply-driven disinflation (deregulation, freer global trade, labour mobility, tech-driven productivity growth, and lower marginal tax rates) but what we have today is a disinflation soon-to-become deflationary trend induced by a credit contraction deficiency in aggregate demand. There is a qualitative difference.
Right now, the markets are looking for direction because the huge rally from the 666 S&P lows last year came to an end as the recovery began to weaken this spring. In recent history, the best analogue for this particular period is 2002. If you recall, the recession of 2001 ended in November 2001 yet the unemployment rate continued up until mid-2003. This partial recovery created anxiety about the strength of any recovery, leading to multi-year lows in October 2002 (I remember because I had a lot of stock options which were underwater as a result). Lacy Hunt and Van Hoisington pointed to anxiety over employment and a partial recovery as the trigger for stocks breakdown into 2002 despite the fact that recovery would last another 5 years. Here’s what they said 12 months ago:
The S&P 500 Stock Price Index troughed prior to the end of all the NBER defined recessions from 1967 through 1999, in concert with the four key economic variables. However, in 2001 the S&P bottomed 15 months after the end of the NBER defined recession yet one and six months before the cyclical troughs in income and employment, respectively. In other words, stock prices anticipated the complete, not partial, recovery of these pillars of economic growth. Although all four of these indicators are still falling, the critical event for the financial markets will be when all four finally turn higher. If a complete recovery of these four variables is still far in the future, then the current gains in the stock market cannot be sustained, just as rallies were not sustained in 2001.
If Hunt and Hoisington are right, then the trough for stocks lies ahead of us and not behind – as employment is still weak. A year on, stocks are quite a bit higher than in July 2009 though. I don’t see us getting back to new lows in this cycle without a double dip recession.
But what about the optimistic earnings numbers that Rosenberg points to? I believe analysts will be disappointed. The economy is slowing already globally. Austerity is reducing aggregate demand, China is working to cool an overheating market and more robust economies like emerging Asia, Australia and Canada are raising interest rates to prevent overheating. All of this says lower growth. Where is the outsized earnings growth going to come from if the global economy is slowing? American firms’ profit margins are already at record levels.
Here’s how I see it. We have been in a bear market rally aka cyclical bull market since march of last year. While the bloom has come off the rose a bit, the experience from 2002 to 2007 demonstrates that there are long and powerful rallies during a secular bear. The difference of course is that stimulus is likely to be less effective in reflating the economy this go round. In fact, political pressure to reduce deficits will be a headwind to any kind of stimulus. I see this as negative for shares.
The economy will slow. To the degree we do slow and are hit by an exogenous shock, we will double dip and shares will go below 666. But, to the degree we can keep the gravy train going, a more muted version of the 2002-2007 could still happen. Clearly, the risk is to the downside though.
Source: Breakfast With Dave (pdf), 14 Jul 2010, David Rosenberg