Too Much Fluff - Features

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.

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.

In our March Active Indexer, "Knowing Your Portfolio Limits," our view was to add equity beta. Five weeks ago, the biggest risk in hedged portfolios was too little exposure to stocks. We acted by reducing short (inverse equity return) exchange-traded funds (ETFs). A few days ago, we closed at 852.06. Is having too little beta still risky? No. After having rallied nearly 30% off the prior low, it is as risky to have too little as it is to have too much beta. Beta neutral is just about right.

Our objective over the next few weeks to months is to balance equity/bond beta with a tilt toward owning assets that source positive beta during inflationary bust periods (see Reflexive Asset Allocation, April 2009, InPerspective). We are also concerned about positioning assets for a huge rally that could take the S&P 500 to about 1,100 over the next few months. Below are some likely trends.

We are in a secular bear that recently began a cyclical bull. The S&P is probably (not certain) going to correct back to 835 - 840 and then stocks are going to:

We are satisfied to be correct about our price trend forecasts, but technical analysis is best at identifying likely price trends. It is not as good at estimating when trends will change or how long they will persist. The above exercise helps us to pay attention to price levels that call for a modification in asset exposure. Remember, we are speculators seeking rewards (alpha).

AI's Axiom: "Capturing desired source returns while avoiding unwanted beta and limiting default risk."

Primary Objective: 75% of the market's (S&P 500 Index) positive and 50% of its negative returns over 12-month periods. This profile drives the model's strategic allocation and tactical trades.

Secondary Objective: The portfolio satisfies a need to employ a capital originally allocated to hedge funds into a proxy but without their baggage (excessive fees, limited transparency, illiquidity and high business risk). Consequently, AI 75/50 has an absolute return objective consistent with meeting our primary objective over 36-month rolling time periods.

Summary Objectives: AI 75/50 first seeks capital appreciation while attempting to provide positive returns over all 36-month time horizons since the portfolio's inception date on March 19, 2004. The portfolio also attempts to best the returns of the S&P 500 Index (S&P) and The Hedge Fund Research (HFR) Investable Global Index (HFRX) during these periods.

As of the trade week ending April 9, 2009, month-to-date (MTD) we are down 0.1%, while year-to-date (YTD) up 5.7%.

Because we are late with the release of this issue of InFocus, Figure 5 returns are through April 15, 2009, which are 0.3% MTD and 6.2% YTD.

Returns for the last three calendar years were -2.2% in 2008, 8.8% in 2007 and 18.3% in 2006. Since the portfolio's inception, the cumulative return has been 51.6% (Figure 5).

Since our last Infocus on March 27, we increased our portfolio exposure to the ProShares UltraShort MSCI EAFE (EFU) by 2% (4% after leverage). Pending good-until-cancel (GTC) orders are to sell EEV at $33.50, half of EFU at $130, and half of SCC at $73.42 and half at $115.

Figure 3 reviews major index and asset class fund returns for the trade week ending April 9, and MTD and YTD through April 14. Here we also list the AI 75-50 Portfolio's over weight, (OW); neutral (N) or, under-weight (UW) positions relative to the Dow Jones Global Stock Index.

Figure 4 plots the prior week's returns by index and asset class exposures. Short exposures are highlighted in red. Shorts are sourced through the embedded leverage had by double inverse ETFs and from directly shorting ETFs. Long positions are colored green.

Below are asset weightings for each position; our beta/non-beta balances; source of return themes; gross, short and net long percentages; and other relevant currently held position data. To the far right are long-term (3 years) strategy views that express core holdings and tactical trades. We are targeting gross exposure of 112% down from our current 147%.

1. Charles Minter and Marty Weiner, What's the Real P/E Ratio?, Barron's May 26, 2008.

Operating earnings exclude write-offs, while reported earnings include write-offs. That is the only difference, but it's a difference that is getting much more important. As recently as the early 1990s, operating and reported earnings were virtually the same. But then we entered the greatest financial mania of all time, and the earnings numbers diverged. There were so many write-offs by companies making unwise investments and then undoing them that operating earnings grew much faster than reported earnings. The write-offs that had been sporadic and unusual became common for many companies. Using operating earnings is now like playing in a golf tournament that doesn't count any penalty strokes for hitting the ball into a water hazard or out of bounds. Look at the numbers. Reported earnings for the S&P 500 for 2007 were just over $66. The operating earnings for 2007 were $84.54. The estimated numbers for 2008 are about $69 for reported earnings and about $90 for operating earnings.

John Serrapere works on research and consulting projects through Arrow Insights. He welcomes comments and suggestions for future columns at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .