Don't Buy (Sell) The Bear

Obviously its a little cliche to call the recent technically-driven furious selloff in the S&P 'overdone' or 'oversold', but that it is. The waters are being probed for value. Its important not to get carried away, however. The last bear was accompanied by S&P earnings of $52 in 2000. Now the S&P is earning $87. The correction will likely be shallower since there is actually more value in the market (just a look at GDP differences of 2000 and 2007 reveal gigantic growth in nominal terms - its important to note S&P is measured in nominal terms).

Here's the basic technical analysis (click both charts to enlarge):

Intermediate support lies another rapid selloff away. Long term support lies at 1220.

Now for a fundamental valuation perspective:

An analysis of price targets and valuation measures: If we hit the 1220 target and achieve a repeat of 2007 earnings for year 2008, that gives us a 14 forward PE. Considering, 2000 earnings of $52 were followed by earnings of $44 in 2001, lets amplify a similar earnings decline onto 2001 assuming the same depth of recession occurs. That takes us from $87 to $74, a 15% decline. That gives a realistic and pessimistic forward PE for entire 2008 of 16.48 with the S&P at 1220. That is a %6.06 earnings yield.

Note that earnings yields (PE ratios) maxed out (bottomed) in the early 80s as the stock market needed to compete with fixed income returns (peaking in the 15% range, versus stock market yields peaking at 12.39%). I don't foresee that repeating.

Interestingly enough, another recession, the one from 1980-1981, saw earnings increase. Not until the recession was over did earnings actually start declining, from 1981 from $15.18, to 1983 at $13.29. There, a total drop of 12% in earnings happened over 2 years (6% annually average). So in actuality, while the recession of the early 80s was considered formally more significant, perhaps easy to notice with oil price shocks, drastic cost-push inflation, and screaming 20% yields, corporate earnings were more noticeably impacted in the 2000 recession.

Regardless of a past superficial diagnoses of past recessions, it is important to have a benchmark to gauge the likely depth the equity markets suffer during the next one. While some deep support exists possibly at 1220 for the S&P, these PE ranges give a lot of wiggle room. While not overvalued by any measure, psychology may dominate in the short term. Looking forward, once the credit default swap liabilities and the entirety of the overdone CDO writedowns (expect markups in subprime bonds and associated CDOs in 3 years) have played out, you are left with fiscal stimulus of low interest rates, likely some more tax cuts, and more importantly no more shorts.

The market is forward looking, and capitulation is all we need. From 2001 to 2007, earnings in the S&P have doubled - a 100% move. If that repeats again, no matter how much you disagree with stimulus methods, we are looking at S&P earnings of $156 in 7 years (give a year for earnings recession). Thats an S&P target of 2350 with a 15 forward PE.

Now if that comes at the expense of the dollar losing another 50% of its value, I'm not one to argue. But that has little to do with S&P price. A 6% earnings yield for the stock market looks cheap against a backdrop of 2.5%-4% riskfree returns, especially when there's nothing more to play out.

Conclusion: Don't be in a hurry to buy this for a double, but downside is limited so long as this isn't the beginning of the great depression, which Ben Bernanke happens to be well studied on.

Disclosure: none

Comments

[goatfarmer:]

True, earnings have doubled since 2001. But more interesting, earnings are almost double those of 1999 when the index was at a comparable level to 2007. As to whether that 100% will repeat again in the next so many years, that's quite an assumption.

Interesting to see a combination of technicals and valuations.

as to the f sharp minor, this reader would prefer to see the bear march to the tune of op.53.

2008 Jan 18 09:47 PM

[D36:]

No offense, but I don't feel that you understand the depth of the problem. Millions of Americans purchased or refinanced property in the past few years and property values have and are declining significantly for a multitude of reasons. If a middle class family purchased a house for $400k and it declines in value 10% (which is on the low end of the spectrum), the family loses $40k on the spot if it decides to sell (which is a whole other problem). Being that a lot of consumption in recent years has been financed with easy debt and that easy debt is disappearing, the recession is not going to be shallow or brief. Banks/others who are holding these mortgages are going to and have lost a lot of money, they are going to lay people off who will then have trouble finding comparable jobs for a while. This isn't even the half of it, but all in all consumption is going to take a major hit and that is going to compound the layoff problem.

We aren't heading for a little bump in the road. Stagflation is coming and this recession is going to be anything but minor.

2008 Jan 18 10:06 PM

[ericinNE:]

Now throw into the mix the very real possibility of just one of bond insurers going belly up behind the subprime paper. And if the fertilizer hits the ventilator before the gov't figures out that buying these guys up and covering that action @ $.50-.60 on the dollar is way cheaper than letting it happen, even just once, we could see a market slide that wipes out two generations worth of market increases.

2008 Jan 19 02:53 AM

[Kunst:]

"If we hit the 1220 target and achieve a repeat of 2007 earnings for year 2008..." Stop right there, my friend. Only in your dreams are 2008 earnings going to ANYWHERE CLOSE to 2007.

2008 Jan 19 10:57 AM

[Reinko:]

I agree most with D36, there can be said a lot more on this detail.

For the source of my calculations go to the Federal Reserve flow of funds sheet where some debt is collected, here is the link:

www.federalreserve.gov...

During the last seven years the debt on the financial sector grew something like 82%, the gross domestic product did not grow that fast. (Just compare Q1 2001 with Q3 2007)

The same goes for mortgages, according to the flow of funds release we have 111% increase.

And what about total domestic non financial sectors?
In Q1 2001 we have 18334.7 billion US$ debt while
In Q3 2007 we have 30640.9 billion US$ debt.

That is over 12 thousand billion more debt!

And the totals are staggering: When you add the debt of the flow of funds sheet together with the Federal emergency spending (not included at that FED sheet) we are over 50 trillion of debt.

That is over 50 thousand billions!

And at an interest level of just 5% there is a need every year for 2500 billion just to pay the interest!

In conditions like this it just makes no sense to compare the present S&P with the 1999 or 2000 S&P.

2008 Jan 19 05:49 PM

[Michael B. ...:]

Nice call on the F# minor. Finally someone gets it.

Here is a response I made on my blog to Reinko:

But whats happening here is a transfer of wealth from mismanaged corporate balance sheets and investors (holders of subprime bonds) to borrowers (many of whom will file bankruptcy). Running up consumer debt, the borrow still gets to enjoy the benefits of the purchasing power he was given, at the expense of the foolish lender.

The fed & US govt knows this, and knows the only solution is to devalue the dollar and inflate future earnings quantities to prevent an excessive slowdown and bankruptcy level. This excessive level of debt (ie 30T) however needs to be compared to cash and equity reserves (401Ks, pensions, cash savings, money markets, total home equity base properly discounted to correction in correspondence with total money supply and inflation, etc.) to have a fair evaluation. If the money supply doubled the past 10 years, then its less meaningful a number. The ratio of debt to money supply is more important.

The fed knows all this and will continue its current policy at the expense of the dollar. This is a weakness of all fiat currencies though, and since this is true, a global economic contraction on the same scale in Europe will hurt the euro just as much. It'll become a question of who hurts more.

Arguing that we're screwed because total debts have doubled in 10 years sounds wonderful to the bear, but it does not present a true picture when considering cash reserves and total money supply has increased as well.

So further conclusions: the dollar will ultimately suffer at the expense of the S&P and housing boom. That is, unless other country recessions follow (which is likely, considering the housing price boom is not something unique to the US).

And if any of you are truly this bearish on equities, I recommend you have a look at this

scriabinop23.blogspot....

and this:

scriabinop23.blogspot....

2008 Jan 20 12:11 PM