If Europe Does Not Send Market Lower Earnings Season Will

by: Turtle Management
Stocks were not cheap a month ago and they are still not cheap here today. As I write this the S&P 500 (NYSEARCA:SPY) (SPX) is trading around the 1,200 level. Using 2012 analysts' estimates of approximately $100 for SPX operating earnings, that puts the SPX at a multiple of 12x. The historical multiple that the market (SPX) trades at has been about 15. In my opinion, 15 is still too high, but that is another debate for another time.
Analysts are notoriously awful at predicting recessions and downturns in earnings. Here is an article from about a month ago where analysts everywhere from Goldman to Barclay’s were trying to say the S&P 500 will be at 1,450 by the end of the year. Sometimes I wonder how these guys retain their jobs. Sadly, this is not the first time (not even close) that analysts ignore economic indicators and remain bullish, failing to adjust estimates downward until the market has already fallen and it’s blatantly obvious the market will not hit the highs they irresponsibly predicted.
Here are two ISM Manufacturing Index Charts. The one taken from Bloomberg.com shows the ISM in a downward trend (hate using technical words) since January. The other taken from a Google search shows ISM collapses being followed by recession. Unfortunately, I cannot take credit for this as John Mauldin pointed out the correlation between the two in his book “Endgame.” Yes you are correct, this does not mean we will be entering a recession, but it is a cause for concern.

More important than weak manufacturing numbers are the layoffs from companies like Bank of America (NYSE:BAC), HSBC (HBC), Credit Suisse Group AG (CS), Barclay’s (NYSE:BCS), Borders, USPS, etc. These will keep showing up in the weekly jobless claims numbers and put upward pressure on unemployment and add to the strain already placed on welfare programs. I believe that we are seeing the beginning stages of a recession brought on by a loss of consumer confidence, spending cuts and austerity in Europe leading to slowed global GDP growth, and large public debts crowding out private investment.
Ironically, I believe we need a deep recession as I believe that we need to cut spending and start the painful process of deleveraging. I am an Austrain and not Keynesian in terms of economic theory. Greenspan and Bernanke have used credit to boost the economy too long. Printing and adding to the debt will not solve the long- term problem. Our demographics (fewer people working, more retiring) and the battle to depreciate one's currency the fastest will not allow us to grow out of our debt. Adding the the deficit and debt with short-term stimulus and spending boosts to prolong the inevitable is just making our situation worse long term. It adds to the pain we will have to experience later on when the bond market dries up and we are forced to deleverage. Let's hope it never comes to that.

Look for the Fed to increase the duration of its bonds and to start issuing more longer maturity securites so it can inflate away our debt like it did after WWII and like the UK is doing now. We can't risk yield spikes due to inflation when we have a lot of short- term debt that needs to be rolled. I don’t believe you will see QE3 in the form of printing, but rather we will be setting ourselves up for inflating out of this mess a few years down the road while trying to do silly measure like “Operation Twist” to keep growth positive.
Back to the SPX. In the early 2000s recession we saw earnings collapse from about $70 to $35 and the market go from about 1,400 to 800 or so. In the 2008 debacle almost the exact same thing happened except the SPX hit 666 from it’s previous high of over 1,400 while we witnessed a trailing twelve months earnings collapse from $90 to $10. No one can argue that growth is slowing, that is a fact. Why is it so hard to believe that instead of $90 or $100 2011 or 2012 earnings we see $80 or $70? In times of duress and falling confidence market multiples come in at about 10x. If you put 10x on $80 you get the SPX at 800. I am not saying that is its fair value, but rather that it is very possible we could see that in the next 6 to 12 months.

In additon, I believe, as the market is pricing, that a Greek default is unavoidable. Banks will need to be recapitalized and I think Greece will eventually get the boot from the EU. It would not shock me to see Portugal booted either. Bottom line is that earnings and recessionary risks as well as Europe are not being priced into the market. It is clear that even defensive companeis like Procter & Gamble (NYSE:PG) are struggling to sell product as they have switched to a barbell strategy (selling very cheap and high-end product) due to the disappearance of the middle class. Banks have already made it clear that they will disappoint and earnings have not been adequately adjusted downward for that risk either.
Ignore the analysts. The risk are far too great to be long the market here. In 2008 the market was flat for a few months after losing 10-15% and then crashed hard. Stocks are not cheap. I am long SPXU (3x bearish ETN on the S&P 500) although I am wary about the risk of ETNs.
Disclosure: I am long SPXU-OLD.