S&P 500: Fair Value Of 980?

 |  Includes: DIA, QQQ, SPY
by: Turtle Management
Listening to the news and reading articles day to day on the market can drive a person absolutely insane. When the market is down we are bombarded with end of the world prophecies. When the market is up (often a day or two after the coming end of the world), the SPX is apparently cheap and going to 1,400 by year end. I wrote an article over a month ago after the first crash when the DJIA was trading around 11,750 saying that stocks are not cheap and that they were more likely to go up than down. Unfortunately, I believe that this is still the case.
The SPX is trading close to 1,200 right now or 12x earnings estimates for 2012. The chart you see shows where earnings of the SPX would be excluding financials, given a growth scenario of earnings. So if earnings collapse in 2012, 20% from where they stand today, we would see about $67 in earnings. This chart will help explain my reason for the market being overvalued and I will come back to it, but first I want to talk about the possibility of a recession, what happens to earnings during a recession, and Europe.

A Recession & the U.S.

Everyone would agree that a recession is a risk. Some people feel that it is 95% likely and others only 25% likely. I fall closer to the 90% camp, but for the sake of argument let’s assume a 50% chance of a recession and 50% chance of flat growth for 2012. Now with our 50% estimate let’s have a look at history.
Right now analysts are forecasting about 9% net margins for corporate earnings going forward through 2012 with 5% revenue growth and the SPX trading anywhere from $100 to $110. During the 2001 and 2008 recessions net margins were around 4% and 5% respectively. In addition, a recession on average (looking at the last 3 going back to 1990) brings about a 33% drop in earnings at its trough. A 33% drop would leave us at about $60 in EPS for 2012 earnings. Since we are assuming a 50% chance of a recession and 50% of flat growth, we will say that 2012 earnings will be approximately $70. The SPX historically trades around 15x earnings so we will use that to come up with a “fair value” for the market (when I say market from now on I am talking about the S&P 500). $70*15 = 1,050.
As you can see, using historical numbers and some conservative assumptions (I think the risk of a recession is higher and that the market won’t be trading at 15x at its trough during a recession) the market at 1,200 today is overvalued and not trading low enough to properly discount the risk of a recession. Now let’s look at Europe.
A Quick Look at Europe
It goes without saying that if the EU breaks up or if the Euro breaks up, the market will go much lower. When looking to go long stocks (since this is a macro driven market) we need to discount the risk of Europe blowing up into our fair value assumption for the market. Most analysts say the risk over the next twelve months is 10% to 20%. I think it is more like 50%. Let’s use 20% though and say that if it happened, the market would retest the 2008 slows of SPX 666. If we have a fair value thus far of 1,050 that means to get to about 700 we need to drop 350. Since we think there is a 20% chance of this .2 * 350 = 70. We should subtract 70 points from the 1,050 value to arrive at our fair value for the market for 2012, 1,050 – 70 = 980.
I have written many articles about Europe and why I think it is doomed as it stands. To summarize, it is all about people. There is no way around the fact that the German people will have to keep paying for Greece and others and they will get fed up at some point. Greece cannot export out of its debt because it is tied to the strong Euro. In exchange for money, the Greeks have been forced to cut spending and implement measures of austerity. This is killing tax revenues (which they can’t even collect from people to begin with due to evasion) and making it harder for them to resolve the issue. There is no fix for Greece except for a default and restructuring of some kind.
To give them a chance and to give countries like Portugal a chance I think that the EU should stay intact, but two currencies should exist for a decade. During this decade the weaker countries must balance their budgets and become more like Germany in terms of fiscal responsibility and work ethic. The temporary weaker currencies for the weaker countries will allow them to grow out of their debt. This will be a little painful for everyone as Germany relies on exports and the absence of weak countries from their currency will cause their currency to rise making it harder to export goods. Despite the pain, doing nothing, continuing to give free money to irresponsible countries who have no chance of fixing the problem in their current state, or just leaving the Euro altogether would be much more painful.
There is no way around this problem without taking some pain. The damage has been done as too many countries borrowed more than they could possibly pay back. Recent austerity in France, Italy, Portugal, and more in Greece will send Europe into a recession just like it has done in the past for Greece and Portugal. This will put a drag on the U.S. economy and U.S. corporate earnings.
The market still has a much better chance of trending lower than higher over the next year. Analysts are notoriously bad at predicting downturns and margins cannot expand indefinitely (they have been proven to have a tendency to mean revert over time). I believe that we will enter a recession either due to the incompetence of Congress, deflation and a blow in Europe, a slowdown in China, or the fact that we are due for a slowdown. I say that we are due for a slowdown because we never really left the previous 2008 recession; we just postponed it with artificial growth thanks to the printing of money. Using what I believe are conservative estimates I place the value of the SPX at 980. Markets tend to overshoot their fair values (go too low in a recession and too high during a boom). My bets in the market over the next year or two are going to be more short than long. It is not ridiculous to say that we retest the 2008 lows within the next year or two, especially if (I believe when) Europe blows up.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.