At the close of the abbreviated trading week on April 9, the S&P 500 S&P stood at 856.56. In our previous column, we identified a possible rally all the way into the 850-950 price rally zone over the next couple of months.

The evidence for a rally then was technical in that it was the most oversold market since 1992 (Figure 1).

In early March, our sights were set on a 28% to 42% rally. That was based on the assumption that the equity/high-yield bond markets would bottom along with a continued waning of severe deflation fears. We said then that the first waning had begun in an ebbing/waning cycle.

At the S&P's March 6 intraday low near 667, the stocks were trading at a 10.6 price-to-earnings ratio based on $63 consensus operating earnings estimates. Late in 2007, the consensus for fourth quarter 2008 was near $100. Earnings estimates of analysts/strategists have been off by more than 50% since earnings peaked in 2007, which does not inspire confidence in P/Es.[1]

We now know, but we did not know in early March, that the S&P's reported earnings -- which unlike operating earnings includes all the bad stuff -- were $14.88 at the end of the Q4. Reported (actual) earnings are still falling in 2009 Q1 and Q2.

So what is the significance of an S&P low at 667? We need a closer look. Standard & Poor's expects earnings to rise by 92% year-over-year with their year-end estimates for 2009 at $28.51. At $15 (2008) and $29 (2009) reported earnings, the S&P records a P/E of $44.5 and $13.6 at 667. This review leads us to believe that Mr. Market is ripe for bigger discounts.

My convictions on sustainable market price trends are high when fundamentals support trends. On April 15, we closed at 852.06. Technicals still say that we are going higher with a good chance that the S&P hits 950 over the next few weeks. After that, there will be a time in May to go away (an old trader axiom) because fundamentals stink. There are plenty of examples, but our focus is on earnings.

Too Much Fluff In Earnings

A large and sudden increase in the difference between operating and reported (or net) earnings usually forecasts continued negative earnings surprises. Such warnings typically precede lower price lows for the S&P.

Just for such reasons, Figure 2 is troublesome. It and other fundamentals do not support an entrance into a new secular bull market.

This chart plots a ratio resulting from the division of operating earnings by reported (net) earnings. As of the end of 2008, operating earnings were $49.51, with reported earnings at $14.88. That equates to a 3.33-to-1 ratio, or 3.33. It was only 1.27 at year-end 2007. This ratio has exploded 236% in three months (since 2008 Q3). Since 1988, the median has been 1.12. This ratio recently was 297% above its long-term median.

I call this ratio the fluff ratio. Too often, earnings are fluffed up by accounting gimmicks, which enable firms to make their quarterly numbers. Early in my career, we were taught to avoid fluffy stocks because many were laden with fraud, or at risk for more negative surprises that resulted in lower stock prices.

Year-end 2009 estimates for operating and reported (net) earnings estimates are now at $61.41 and $28.51, or at a ratio of 2.2. If so, things would still be amiss. At the start of 2008, reported earnings estimates were $84. By year-end, they were $14.88. That is a -82% miss. Things were not any better for operating earnings. Since January 1, 2009, operating earnings estimates for the S&P 500 have dropped from $75 to $59 (a 34% decline in three months). Do you want to bet that estimates will not continue to decline?

Secular bear markets end with PEs in single digits. Why would the current bear not? We are in the worst recession since the Great Depression.

On April 15, the year-over-year industrial production declined by over 19%, which is even worse than during the early months of the Great Depression. Ditto for the global collapse in trade. The severity of many macroeconomic declines portends that local/global fundamental trends will remain subpar for years. History shows this to be the case. Unless it is different this time.

Previous Page

1  |  2  |  3  |  4

Next Page