John Mauldin has an excellent new report out regarding 2009. If you don’t follow him he’s a must read. His website can be found at www.2000wave.com As I have in the past, Mauldin covers the importance of earnings in this recession. In my opinion, stocks will not make a sustained advance until earnings begin to trough or rebound. In essence, when you purchase a stock you are buying the right to participate in the future cash flows of the corporation. If those cash flows are negative there is no demand for the asset. The asset will not regain price stability until the cash flows steady or begin to pay dividends. You would never buy something if you didn’t think it was going to be more valuable in the future. This is why stocks fall when a company reduces its guidance. In the current environment earnings are still very weak. Mauldin covers the relationship between estimates and real earnings in some detail in this weeks report which can be found here: https://2000wave.com/article.asp?id=mwo010209 – the site requires free registration, but it’s certainly worth the investment.
So, how did the US market respond to this data? The Dow was up 258 (almost 3%) and the NASDAQ up a sprightly 3.5%. Nothing to worry about.
However, earnings, as you might expect, are not doing all that well. For the last year I have been highlighting how earnings estimates are dropping for the S&P 500, as analysts try and catch up with the reality on the ground. They are still behind the curve.Let’s look at their estimates for earnings in 2008.
They started at $92 in early 2007 and are now down to $48. This chart is not something to inspire confidence in stock analysts.
On a trailing one-year basis, that puts the Price to Earnings Ratio (P/E) at over 19 as of today’s close at 925, which does not make the market cheap. But last year’s earnings are history. What about 2009? Again, the analysts are in a race to finding the bottom.
The current projections are for $42.26 for 2009. That makes the forward P/E 22. That doesn’t look like value at all, when the historical average is closer to 15.
Bulls would argue that the market is forward-looking and that all the bad news has been priced into the market. I would counter that the market has so far done a bad job of pricing in bad news, given the fall of the markets last year in the face of a recession. As I repeat incessantly, the US stock market falls an average of 43% during recessions. The stock market was not discounting a recession last January or even in May, even after a very serious financial crisis.
But how bad can it get? Analysts must surely by now have lowered their estimates to more realistic numbers. Shouldn’t we start to price in the recovery from here? Well, no, not if you look at the last recession.
In 2001, as-reported earnings were $24.67. Operating earnings in 2002 were $27.57. Does anyone think the current recession will be milder than the last one? Or shorter?
And it gets worse. Core earnings, which take into account pension and other under-reported liabilities, were less than $16 in 2001, and so P/E on a core earnings basis topped out at 71, and on an as-reported basis were as high as 46!
Of course, after that the stock market went on a tear, almost doubling over the next five years. And today the market seems to be suggesting that many people are afraid to miss out on the fun of the next bull market run.’
Mauldin hits the nail on the head. The, “equities are cheap” argument doesn’t fly in this kind of an environment becaue the evidence simply isn’t there to make such a preposterous argument. It’s hard to get really bullish on the market until earnings estimates become more in-line with reality or the stock market falls to a point where the market is actually cheap. Thus far, I don’t see any evidence leading me to believe that earnings are troughing or even close to improving and until I see the future cash flows of U.S. corporations improving it is nearly impossible for me to get really bullish on the stock market. I think we’re close to the point where the pendulum might be swinging into a more bullish posture, but we’re likely a few more quarters away.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.