Priced for Recession....and Then Some

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Includes: DIA, QQQ, SPY
by: Vinny Catalano

In this week's report, my proprietary Expected Return Valuation Model [ERVM] produced a result that a good friend of mine noticed matched quite tightly with the historical data of earnings declines in recessions.


The EVRM has the market trading at fair value on the assumption that, in a worse case scenario, earnings decline 22% this year. History shows that the last two recessions (2001 and 1990) produced earnings declines of 31% and 24%, respectively. Clearly, this is the thinking that pervades most investors. At least, as of today.

What this suggests is twofold:

• The market has already reached a zone of a realistic worse case scenario valuation with an overshoot to the downside likely.
• Any changes to this view will have an immediate impact on present value levels.

Two positive factors to consider:

• Should decoupling show itself to be more resilient than the bears think, upside adjustments to the current worse case scenario thinking will take hold rather quickly.
• If the fear of more credit derivative shoes to drop diminishes, upside adjustments will also take hold rather quickly.

Investment Strategy Implications

I would argue that both positive factors will occur in some form before this quarter is over as the global growth story is more well entrenched than the bears give it credit and that the worst of the credit derivative write-offs are behind us. Moreover, an election year has a way of producing a sense of urgency that should inspire elected officials to act more swiftly.

Many have equated the current economic climate to that of 1990. If so, the short but violent 20% decline in equities that took place then has already been achieved now. All that's left is a capitulation of the bulls.

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