Sent: 17-03-2009 12:16:02
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Guessing the Direction of the US Market
The U.S. stock market might have reached a bottom but we cannot trust the earnings estimates enough to enter the market with conviction.
Conceptually, if we had a firm grasp of S&P 500 earnings, we could take a stab at when to start buying the market by setting a target p/e ratio. This harks back to my ATC e-mail note from 9 December 2008 in which I highlighted analysis showing how the US market tends to be weaker in the years after p/e's have been high and stronger after p/e's have been low.
Right now, the estimate for S&P 500 operating earnings in 2009 is US$64.37. That suggests a p/e of 11.8 based on the 757 close for the S&P 500 last Friday and a market which is historically cheap. There might be an argument for buying now.
However, stock analysts have persistently overestimated the earnings in this cycle much as they have always been prone to do when the macroeconomic momentum is turning down. This occupational hazard arises usually because they rely too heavily on the guidance of company executives and insufficiently on a soundly based macroeconomic framework to generate estimates of the elasticity of corporate profits in response to changes in macroeconomic aggregates.
Despite how frequently their views are sought, company executives are generally poor at anticipating changes in business conditions or, at least, admitting to them tending to confirm changes only after they have already occurred.
Can anyone imagine an executive appearing on one of the television business programs saying that his company is going to suffer more than other companies from an economic downturn in the coming year and nothing he can do is going to avert a profit slide. It just never happens. Every executive seems to have a cunning plan to safeguard his business so that even if the company floundered in the last cycle, this one is going to be different.
Coping with these tendencies has been doubly difficult for analysts in the current cycle because even the more pessimistic macroeconomists have overestimated the strength of the economy (or underestimated its weakness) and, therefore, the likely strength (or weakness) of corporate profits.
The current estimate for 2009 S&P 500 earnings is 31% above the actual outcome in 2008. At face value, this is far too optimistic as it implies that an earnings recovery is already well underway, despite the macroeconomic data suggesting otherwise.
S&P 500 earnings contracted for the only time in the past 20 years during the fourth quarter of 2008. Earnings for the prior three quarters of 2008 were 26% lower than they had been over the corresponding period of 2007.
Given the severity of current economic conditions, S&P 500 earnings in the second half of 2009 could easily be around half the level which had prevailed in 2007. If we are to have a mid 2009 recovery, admittedly a seemingly heroic assumption at this stage, earnings in the first half of 2009 might still be 50% lower than in the second half. That would leave us with earnings for 2009 as a whole just over 30% lower than in 2008 and, at last Friday's close, an expensive p/e ratio of over 22.
If we still thought a p/e ratio around 14 times earnings was an appropriate target buying price, we would have to target a market entry point for the S&P 500 of 476, with this earnings scenario, or a further 37% below the current market.
The accompanying table (also available at http://www.thebigpicture.com.au/atc/s&p_outcomes.htm) shows potential S&P 500 levels for different combinations of earnings changes in 2009 and targeted market multiples. The table suggests that the actual market value at the close of business on 13 March was consistent with, among other possible outcomes, a slight increase in earnings of up to 10% in 2009 and a 14 market multiple.
We all have to make our own judgments about how reasonable such an assumption might be amidst the full range of possible outcomes.
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