What I am smoking? Did I say S&P 1600? Fine, I said it, but I did not say when. Let me guess, 2014? A number of things need to happen by then, and they may not. However, now that my major pivot point of 1194 has been reached once again, I am pushing the envelope and stacking the chips to make the bet. If you have the patience to wait, here is how it would work.
We all know the stock market is “cheap”. This is a very relative notion. Cheap can become cheaper, indeed goods do not go on sale unless they don’t sell. So, in relative terms, the institutional way to calibrate financial asset prices is relative to the risk-free Treasury 10-Year note. For argument’s sake, please save me the rhetoric on the risk-free nature of US government paper. The chart below illustrates the historical relationship between the earnings yield (EY), which is the reverse of the P/E, and the 10-Year note.
[Click images to enlarge]
It comes from my 2009 book and has not been updated. The drop to the right in the grey line, the EY, dates back to early 2009. This is when the P/E plunged, and illustrates that ratio analysis require a look at both the numerator (on top) and the denominator (on bottom). In this instance, the P plunged, but the E plunged even faster, driven in particular by financials which represented some 25% of the S&P at the time.
Since then, the EY has consistently traded at a large premium to the 10-Year. Currently, with the collapse in bond yields, it is at an historical 6% or so premium. The prevailing forward S&P Earnings estimate is around $96, for an EY of 8%, whereas the 10-Year is at 2.1%. By the same token, the P/E is 12.4, at the low end of the 14 to 26 range of the post-WWII non-inflation periods. The only time it broke that range was in the ’73-’82 period, further to the food and oil inflation shocks and baby-boomers induced inflation, when it traded in the 7 to 14 range.
Here is my first assumption. Despite the massive increase in the monetary base, worldwide, we are not about to enter an inflationary spiral a la 70’s. We may pick up a bit, here and there, but right now and for the foreseeable future, we are merely offsetting deflation. It’s my “tire analogy”: your tire is deflated, the car won’t run – that’s deflation; reflate it, it will – that’s back to normal; if you put too much pressure, it’ll blow up – that’s inflation. Central banks are acutely aware of this, and demographics do not support a 70’s scenario except in China, at the margin.
So, I see no reason why P/E should not trade back up to their historical range of 14 to 26. Call 20 the mid-range, bearing in mind that financials weigh much less than they used too, as they now account for only 15% of the S&P 500. This would mean an EY of 5%, for a premium of say 2.5% assuming the 10-Year trades at 2.5%, not a stretch. By the historical norm, this still would be “cheap”.
However, as I mentioned before, there are two components to a ratio. Put another way, the change in P is equal to the change in E times the change in P/E. Assuming P/E go back to 20, what is my assumption for E? Horizon 2014, it is tough to say. Chances are we could reach $100, in which case my target should be 2000.
The reason I say 1600 is two-fold. First, it would meet the previous two historical tops of 2000 and 2007. Given what we have been through since then, not only market wise but also in terms of structural changes in the economic and financial, as well as political landscapes worldwide, I’ll take it. Anytime.
Second, short term, I still expect echoes from Europe and China to weigh on estimates. Assuming a severe 20% haircut, this would yield a forward $80. Times 20 equals 1600.
Could this happen sooner than 2014? Sure. My hold back is the still lingering European situation and the US elections. Europe, in my opinion, is now more of a headline than a disruptive factor. When Luxembourg Prime Minister Jean-Claude Juncker says (on 10/10 on Austrian TV) that Greece’s haircut is likely to be around 60%. He should know, Luxembourg is home to the EFSF, the EIB, and a number of other International Financial Institutions. Indeed, it has one of if not the highest GDP per capita in the World, at $110k, more than double the US.
When the Ministry spokesman then makes amends, it usually means it is pretty much baked in. Witness the markets’ lack of reaction yesterday 10/11, to include “concerns” about Slovakian support for the European bailout plan – where is Slovakia, again? Quick answer: Central Europe, population 5.5 million, GDP $90 billion, GDP per capita $16k. A Powerhouse indeed.
My main concern is the U.S. elections. As I expected back in 2009, this is turning out to be the worst mudsling I have seen in my voting life. It is so beyond my whatever that I won’t even comment here. Suffice it to say, it introduces a palpable element of uncertainty, to include civil rioting with the Administration “understanding”, in National Economic Council Gene Sperling’s own words today on CNBC. That’s all we needed. Bill Clinton’s archetype speech writer, master demagogue and $900,000 Goldman Sachs advisor as a spokesman for “Occupy Wall Street” – see the Harvard Business Review .
That being said, politics may or may not put a lid on the market. I sensed they were going to drive the economy through 2010 – see my book. This did not prevent the market from doubling from the 2009 March lows. By then I would have expected Obama to have moved back to the center. Instead, he has moved to the left. Given the state of the economy, conventional pollsters consider he is losing his base and that he is now up the creek. Indeed, even the dollar says so, as it tried to strengthen on European woes, only to retreat again at the first sign of “real” improvement over there.
With the bloom off the Obama rose, and no visible pick-up on the economy’s EKG, there may be continuous pressure on the E, as well as on the P/E. With my objective of 1600 in my mind, I’ll stick to my previous target of 1270 for the short term – see my article of 9/27 titled: 'There Will Be No European Liquidity Crisis'.
However, I cannot completely obviate the stampede scenario. Let’s face it. The consensus is that 1) the economy is stuck in Washington’s mud; 2) this will cause Obama’s demise; 3) as an aside, it will also cause Pelosi’s, Reid’s and Barney’s – and Bernanke’s, but he is not really the type to take it personally. The others are, however, big time.
Even Dodd has already jumped ship. What could they wish for? A stampede! Stock prices would go up. In a show of much required leadership, they would clean up “Occupy Wall Street”. Household Net Worth and Pension Funding would dramatically improve voters’ sentiment. The economy would follow suit and Republicans would have to scramble. Such a nice idea. What then could be the trigger? Something has to come first.
It’s the liquidity, stupid! It’s been there, dormant as excess reserves at the Fed and at the ECB, for two years now. Bernanke has been scratching his head in light of the banks reluctance to lend. I have written extensively about this so I won’t rehash. What would be the new twist? The other consensus proven wrong: the news of Europe’s death has been greatly exaggerated. What’s the sequence of events here?
First, contrary to popular belief, Europe sneezed, but it did not catch a cold. It finally listened to yours truly and to Tim Geithner, and nationalizes, recapitalizes, monetizes, securitizes, sanitizes, and guaranteezes, not necessarily in that order. The net effect is that banks will need a bit of money, here and there, but not the $3 trillion excess reserves they hold.
Second, what will they do with it, now that they no longer can play the Treasury yield curve? They have to take risk again, i.e. lend. And the third character of my book’s Three Little PIIGS, Dr. BenBee, the well-known TV handyman with a bag full of tricks to include this new “structurally engineered” material called QE, wins the Nobel prize in Goldilocks.
What does that have to do with stock prices, you may ask? Rewind. The earnings yield premium is off the charts because of the perceived risk in a European financial liquidity crisis, been there, done that. Because there WAS no European financial liquidity crisis, the earnings yield can now regress to the mean. Until the excess liquidity is mopped up by the real economy, it provides the fuel for the Stampede.
I told you this would require for a number of things to happen. So why hasn’t it happened yet? Who do you think I am, a magician, a guru? I don’t know, and I’ll be happy to just call the trend. I already stuck with my bottom call, don’t expect me to be right all the time.
That being said in all simplicity, let’s look at the technicals. I know, they don’t count, which is why I spend time drawing lines of all sorts. Turns out some people look at them, including the machines. The medium term one below is a bit murky with numbers, but I did not want to delete and then redo the work. It shows S&P 1210 as trendline resistance, and 1280 as a combination of trendline and Finonacci retracement (see on the left scale) – I’ll take anything in the 1250-1280 area. If indeed we have a stampede, it is impossible to gage of the speed and the magnitude.
The short term one illustrates much more visibly the 1195 pivot point, and the 1210 resistance. It’s now up to liquidity and Q3E, and we’ll take it from there. As one of my fortune cookie says, two small jumps are sometimes better than one big leap.