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Applied Research
Our focus is on understanding economic fundamentals in a manner that preserves risk-capital for hedging and advancing portfolio values. Fundamentals drive price trends until others recognize that the fundamentals no longer support prices. This is true for cheap and dear assets. Fundamentals and raw prices are quantitative, while investor recognition is behavioral (fear-greed). For a grasp on how to tie economic fundamentals with trading and investment opportunities, my favorite sources are John Murphy, Jim Rogers, Victor Sperandeo and George Soros.
Earnings & Recovery
Issue 1 of our February 2009 InFocus raised the possibility that trailing 12-month reported earnings (TMT) for the S&P 500 might crash from near $86 in 2007 to about $16 by 2009 Q2. Analysts at Standard & Poor's Equity Research are entertaining this result. Sixteen dollars is only 12.5% below S&P‘s $18.29 estimate for S&P 500 companies for all of 2008 (Figures 1 & 2). Figure 1 was first published in the July 2006 Active Indexer.
It was adapted from research that I published in Corporate Finance Review (Thompson Financial) in 1998, which included contributions from John P. Hussman, Ph.D, who was then a professor at the University of Michigan. John is now the founder and portfolio manager of Hussman Funds. Figure 1 is at the heart of John's investment thesis. A pillar of his thesis is that stock valuations are supported by earnings growth that has averaged 6% annually since 1940 (red trend line). Hussman calls it the sustainable growth line, which is at the core of stock returns. Stocks are fairly valued when their reported earnings trend line (green) hugs the red line.
Extreme readings above and below the red line are periods of extreme over- and undervaluation. Since 1940, the greatest overvaluations were near Peak Earnings in 2000 ($54) and in 2007 ($85). Stock were cheapest near trough earnings in 1982 ($13), 1987 ($16), 1991 ($16) and 2002 ($25). TMT estimates are $18.29 for 2008 Q4 (-79% below peak 2007 earnings).
A table from Standard & Poor's is in Figure 1. It shows a -73% crash in earnings from 2007 Q4 to year-end 2008 with a price-to-earnings ratio (P/E) of 38.31. Their TMT estimates for 2009 Q2 range from $14 to $16.
The S&P is near trough earnings levels that have rewarded investors handsomely since 1940. Our investor appetite is restrained by a climate that resembles a world more like the one that existed prior to 1940.
Figure 2 was updated. It first appeared in Defend & Advance and Panic P/Es at http://www.indexuniverse.com/ in March 2008 and October 2008, respectively. Our defensive posture since May 2006 was warranted. Since October 2008, reported earnings have collapsed from $52 to $18. Panic P/Es found eight credit panics since 1873 when stocks troughed near 12 times (x) deleveraged earnings. Figure 2's 12x results are all negative. They put S&P prices well below levels seen at 16x TMT (the mean leveraged P/E). De-leveraged troughs will ultimately support a bottom near 219 to 607. A bottom about 11% below the S&P's March 5 price is likely because we are near the final solution for our debt crisis centered around dollar debasement, which will likely keep the S&P near 600 (nominally).
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