Deep thoughts from an unswayed bear, David Rosenberg:
Never before has the S&P 500 rallied 60% from a low in such a short time frame as six months. And never before have we seen the S&P 500 rally 60% over an interval in which there were 2.5 million job losses. What is normal is that we see more than two million jobs being created during a rally as large as this.
In fact, what is normal is for the market to rally 20% from the trough to the time the recession ends. By the time we are up 60%, the economy is typically well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended. In other words, we are witnessing a market event that is outside the distribution curve.
While some pundits will boil it down to abundant liquidity, a term they can seldom adequately defined. If it’s a case of an endless stream of cheap money, we are reminded of Japan where rates were microscopic for years and the Nikkei certainly did enjoy no fewer than four 50% rallies and over 420,000 rally points in a market that is still more than 70% lower today than it was two decades ago. Liquidity and technicals can certainly touch off whippy tradable rallies, but they don’t take you all the way to a sustainable bull market. Only positive economic and balance sheet fundamentals can do that.
Another way to look at the situation is that when you hear and read about “liquidity” driving the market, it is usually a catch-all phrase for “we have no clue” but it sounds good. When we don’t have a reasonable explanation for what is driving prices our strategy is to watch from the sidelines and express whatever positive views we have in the credit market and our other income and hedge fund strategies.
As for valuation, well let’s consider that from our lens, the S&P 500 is now priced for $83 in operating EPS (we come to that conclusion by backing out the earnings yield that would match the current inflation-adjusted Baa corporate bond yield). That would be nearly double from the most recent four-quarter trend. Not only that, but the top-down estimates on operating EPS, for 2009 are $48.00 for 2009; $52.60 for 2010; $62.50 for 2011; and $81.00 for 2012. The bottom-up consensus forecasts only go to 2010 and even for this usually bullish bunch, operating EPS is seen at $73.00 for 2010, which means that $83.00 is likely a 2011 story. Either way, the market is basically discounting an earnings stream that even the consensus does not see for another two to three years. In other words, this is more than just a fully priced market at this point.
It is, in fact, deeply overvalued at this juncture. Imagine that six months after the depressed lows we have a situation where:
• The trailing price-earnings ratio on operating EPS is 26.5x. At the October 2007 highs, it was 18.8x. In addition, when the S&P 500 is trading north of a 26x P/E multiple on trailing operating earnings, history shows that at these high valuation levels, the market declines in the coming year 60% of the time.
• The trailing price-earnings ratio on reported EPS is 184.2x. At the October 2007 highs, it was 23.4x. In fact, just prior to the October 1987 crash, the P/E ratio was 20.3x (not intended to scare anyone).
• The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the market is trading as it if were at a peak for the cycle, not any longer near a trough. Once again, and we don’t intend to sound alarmist, the price-to-dividend ratio just prior to the 1987 crash was 12x, and at the time, the S&P 500 was viewed in many circles to be at an extended extreme.
Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which of course will never occur again. Fine, on one-year forward (operating) earning estimates, the P/E ratio is now 15.7x, the highest it has been in nearly five years. At the peak of the S&P 500 in the last cycle — October 2007 — the forward P/E was 14.3x, and the highest it ever got in the last cycle was 15.4x. So hello? In just six short months, we have managed to take the multiple above the peak of the last cycle when the economic expansion was five years old, not five weeks old (and we may be a tad charitable on that assessment). As an aside, the forward multiple on the eve of the 1987 stock market collapse was 14x and one of the explanations for the steep correction was that equities were so overvalued and overbought that it was vulnerable to any shock (in that case, it came out of the U.S. dollar market). It certainly was not the economy because that sharp 30% slide took place even with an economy that was humming along at a 4.5% clip.
In other words, valuation may not be the best timing device, but it still matters. If the S&P 500 was in a 700-750 range, de facto pricing in zero to 1% real GDP growth, we would certainly be interested in boosting our allocations towards equities. But at 1,060 and over 4.0% GDP growth effectively being discounted, we will be spectators as opposed to participants, understanding that the key to success is to NOT buy at the peaks. So the strategy is to sit on the sidelines, be selective in our equity choices, and wait for the correction to come or for the fundamentals to catch up with this overvalued, overbought, overextended market. Remember, the reason why the tortoise won the race was because the hare got tired.
One more thing, when people look back at this period, they are very likely going to ask themselves why it was that they never paid attention to the volume data, which, like the bond and money market, never confirmed the veracity of this very flashy bear market rally. We reiterate, Japan enjoyed four of these 50% power surges in the context of a market that is still down over 70% from its highs of two decades ago. So remember, rallies in a bear market are to be rented; never owned. For those that never took the opportunity to get out at the lows today have this glorious chance to do so at much better prices, but the question is whether greed has overtaken their long-term resolve, especially now that Gordon Gekko is making a return to the big screen.
Source: Gluskin Sheff