Right now I’m hearing to the most-contemptible creatures — long-only money managers — urging investors to play the coming bottom.
A key part of their argument is that multiple contraction — the adjustment of S&P 500 (SPX) stock prices to new earnings forecasts — is at an end. And the panic may soon end with the blow-off.
We will probably see the market (sort of) crash, the pundits scream “blow-off” and “buy, buy, buy” — and then the markets will experience another leg down.
Why?
Because the general market is trading much more on fundamentals than we can see through this volatility.
Don’t believe me?
S&P earnings estimates are down 30.5% since Labor Day, and the market is down 32%. Coincidence?
How Do They Count to 100?
One of these long-only money managers I heard on CNBC was talking about the S&P 500 having earnings power of $100 per share, and saying that we will eventually come off these bottoms for earnings and regain that level.
If the $100 figure is correct, then the S&P 500 should trade between 900 and 1,500 — it is now a bit below 900.
But this money manager is assuming that this is a normal recession, that credit markets will return to normal and forecasts will begin to reach $100 in 12 to 18 months.
Yeah, right.
This recession is not going to play out that way. This one is going to be a doozy.
I see S&P earnings hitting $40 to $50 a share (if we are lucky) in the next four quarters, and then rising slowly — very slowly — for several quarters after that.
Here are some of the reasons why:
1. The amount of credit available to consumers and businesses around the world will fall about 55% to 60% from its peak last year — maybe more — after the credit markets return to normal.
Note that this is not the forecast for credit during the crisis — this is the forecast for credit after the crisis is over.
This is also not just my opinion. It’s simple math.
Banks lending out 33 times what they have in equity are now racing to lend out 11 times their equity in the United States. In Germany, the leverage was closer to 50-to-1, and that is being pulled in. (And this assumes businesses and consumers qualify for that credit.)
Less credit, less spending and less business growth means lower earnings for the S&P 500.
2. The housing crisis is going to re-accelerate by year-end as option ARM mortgages default in waves, and layoffs provoke more defaults and foreclosures.
This, in turn, will put downward pressure on home prices and reduce the ability of mortgage holders to refinance, causing more defaults and foreclosures. More defaults and foreclosures mean consumers have less money to spend on other things and more write-offs for banks, which means fewer loans to consumers and businesses.
This cycle will go through the middle of 2011 — that’s right, not 2009, but 2011. Again, this means less credit, spending and business growth, which means lower earnings.
3. Falling home prices and fear means no one is using home equity credit lines anymore.
Withdrawals from home equity lines in 2005 were $595 billion, and that translated into a 3% rise in the GDP. In 2007, this number was $470 billion, or about a 20% rise in GDP.
Year-to-date, it is on an annualized rate of less than $40 billion — a 90% drop. That means negative GDP growth — without reductions in income due to payoffs, etc. And (again) that means less spending and less business growth, which means lower earnings.
4. The $700 billion from Uncle Sam is not going to be used to create new loans, spending or jobs, but rather to shore up bank balance sheets.
And that is about 40%-50% of what banks need to raise in the United States alone to repair their balance sheets. This will not happen quickly.
With all that dough simply being parked on balance sheets, guess what? Less credit, spending and business growth, which means lower earnings.
This data sets the stage for analysts’ revisions to consensus estimates for S&P earnings in 2008 and 2009 — revisions that have been coming fast and furious. But I believe there are more to come.
Take a look at the changes in consensus estimates for 2008:
- March 2007: $92
- June 2008: $71-$72
- Last week: $55
The latest estimate puts the S&P 500 at a multiple of 15-16 of current earnings, the high range, historically, for the S&P.
Let’s look at changes in estimates for 2009:
- March 2008: $80-$82
- Labor Day: $64-$67
- Last week: $47.50-$49
This puts the S&P 500 at a multiple of 16-17 of future earnings — again, historically, the high range for the S&P.
Analysts also argue that dividend yields are pretty high, but they seem to forget that these will diminish as companies reduce earnings and cut dividends.
Now, let’s do some math:
Higher range of S&P multiples of earnings: 15, or an S&P 500 of 725 next year
Middle range of S&P multiples of earnings: 12, or an S&P 500 of 580 next year
Low range of S&P multiples of earnings: 9, or an S&P 500 of 435 next year
This is all on the assumption that earnings forecasts — and actual earnings — are not lower. Yeah, right — but that’s another column for another day.
This Could Be Bad
Back to the now — the current market is trading at roughly 18 times next year’s latest consensus forecast for S&P earnings. If the market adjusts to longer-term historical norms, we could see a trading range of 435-725, or declines ranging from 16% to 50%. The S&P is currently trading at 865.
Is this relevant in today’s market?
Far more than most people realize given the current state of market “panic” earnings forecast. S&P earnings estimates are down 30.5% since Labor Day and the market is down 32%.
A coincidence?
Think about it.
Michael Shulman is the editor of ChangeWave Shorts. To learn more about him, read his bio here.
