Will the Stock Market Coast Through the Storm?

As I reflect on my experiences over the past weekend, it strikes me that investors today are practically hard-wired to “buy on weakness”. It is a great idea, generally, except when it is not. I think that this is one of those times.

I had the opportunity to do something at a Six Flags (SIX) theme park this weekend that I had never done before: Skycoasting. For those not familiar with the thrill-ride, my two kids and I were strapped in and hoisted up 200ft and then released to fly over one of the pools at the water park. I wasn’t frightened, as I knew that we were secured to the wire, though it sure was exciting, especially for my kids.

How many equity investors today believe that they have a wire supporting them? Whether it is the Fed coming to the rescue or just the history of success in buying during challenging times, many investors have, in my opinion, a false sense of security. I have written over the past several weeks about my concerns and why my expectations of just a correction have transformed since late May to my acceptance now that we won’t avert a recession. One of the key points in my thesis is that the mighty consumer, who has proven to be much more resilient than economists could ever have projected, is about to find out that credit cards are not an inalienable right. I have been looking for evidence of the credit crunch shifting to non-mortgage related areas, and today’s Wall Street Journal points to several examples of tightening standards. There is nothing the Fed can do to make or incentivize banks to NOT rein in their exposure on this front, and the contraction of available credit and the escalation of its cost will have an even greater consequence than the much-discussed mortgage crisis.

I have previously discussed the erosion of support for the stock market, citing the end of the LBO bid, the weakening of the consumer and the probably contraction of global economic strength. Today I would like to debunk the myth that the market is priced so conservatively that it can withstand these pressures. While it is true that the overall PE of the market (S&P 500 (SPY)) is about 14X 2008 EPS, that is somewhat misleading in several regards. First, the index is weighted heavily with Financials, which drag down the overall PE substantially. Also, Energy stocks are a big detractor.

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Second, the broader market is much more expensive on a PE basis after years of stronger performance – the Russell 2000 trades at about 18X 2008 estimates. Finally, and perhaps the most overlooked, the estimates are based upon peak operating margins and may not be realized. In fact, I recall seeing a lot of work 7 years ago indicating that poor stock returns don’t follow high PE valuations but rather lower ones. It’s kind of strange, but I urge you to get hold of Tobias Levkovich’s (Chief U.S. Equity Strategist of Citigroup) very pretty chart that indicates the market does best when the PE is not too high OR too low. At any rate, our companies have been very fortunate to have benefited from a significant amount of cost reductions over the past decade or so: Improved productivity, outsourcing and off-shoring, stable inflation, etc. Are these changes permanent? Has the low hanging-fruit been harvested? Are the safety concerns regarding Chinese imports of things adults (or kids) put into their mouths a valid deterrent to continued gains from this avenue? I expect that corporate profits will continue their declining growth and go negative. With all of the write-downs coming in the near future from the Financial sector, this is not much of a call.

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As you can see in the chart above, pre-tax margins have escalated to 13% as of the end of 2006 for the S&P 500. EPS year-over-year growth has been pretty flat around 15% for 18 months or so, a bit above the longer-term trend of 12%, though it has tailed off in the past two quarters a bit. Corporate profits (GDP derived data that obviously goes well beyond the S&P 500) show that the growth in corporate profits is eroding. What’s next? The very real possibility of a decline in EPS. The math is simple – revenue growth slows, and margins contract, leaving overall earnings lower. If sales go up 6% but the net margin falls from 9.5 to 8.5, earnings decline by about 5%. We are 5 years into the cycle – not too off-the-charts in terms of odds.

So, all you thrill-seekers out there, be very careful buying the dips. Buying in October, long considered a great time to pick up stocks, makes a lot of sense: October 2008, that is. Not only do we have a possible recession to contemplate, but we will also be enduring the uncertainties of a presidential election. If I am correct about the state of the consumer (the voter), there could be a lot of discussion of government interventionism during the election year, a backdrop not likely to encourage investors. Unlike the Skycoaster, there isn’t a lot of support for equities.

As an aside, I took a look at Six Flags (SIX) as a potential short idea. I have little doubt that this company is going to have very tough times, but the stock is so beaten down that it is probably too late to short. Terrible balance sheet is an understatement. Further, their customer base looked very “sub-prime” to me. I am not so sure that those folks will be able to pony up $15 to park and $7 for a slice of pizza much longer.

Comments

[tclwrap]

very funny conclusion. Started off talking about SIX as a great experience, ended up wanting to short it...
LOL

[AlanBrochstein]

Hey, a couple of points. First, I made a lot of money shorting SCHW (back when it was SCH) in the bubble. I loved Schwab, but the stock was overvalued. Second, I didn't mention this, but the park was absolutely empty. I inquired and learned that it had been that way all week. It doesn't matter if people like Six Flags - what matters is whether or not they will spend their time and money there.

[tclwrap]

the article is very good. I also liked the humor.. Thank you! :-)