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Page 7 of 10
Figure 7 shows the emperor with no clothes. He is weakened by structural trade and debt imbalances unsustainable by recycled trade dollars. The emperor is left with a bubble economy that is overly dependent upon the financial sector. What exposed his nakedness?
Plotting the differential between reported earnings growth (EG) and our nation's nominal gross domestic product growth (NGDP) rapes the emperor. This simple exercise blows up the Brave New World.
Figure 7 plots the monthly change in the S&P 500's (S&P) EG and NGDP since 1947. EG historically has been about 0.50% (6% annualized). The monthly change in NGDP has been close to 0.60% (7.2% annualized). Normally the difference between EG and NGDP is -0.10% (0.50% minus 0.60%) or slightly below zero.
The table embedded in Figure 7 shown as EG-NGDP stands for reported earnings growth minus nominal gross domestic product. The symbol LQ is also in the chart. LQ represents low quality stocks. HQ references high quality stocks or firms with high dividends and steady earnings growth.
Wild swings in EG minus NGDP occur in unstable times. Notice the monthly standard deviation (SD) in EG-(minus) NGDP was 1.50 from 1968-1999, a period of sustainable debt carry (a leveraged P/E). After 1999, as our nation's debt-to-GDP ratio exceeds 3-to-1, the debt buildup distorts the market's sustainable EG and our economic growth rates (low-quality MPT inputs).
NGDP drives corporate earnings, not GDP net of inflation (real or RGDP). Economic growth must remain higher than EG's 6% historic earnings growth rate to support long-term equity valuations near the S&P's historic mean price-to-earnings ratio (P/E) near 16. It is important to note that a P/E near 16 has seldom been likely while the world is deleveraging.
Near the end of the 1990s bull market, the debt bubble reinforced a belief that earnings could consistently grow by 10% or more and that sustainable NGDP was 10% (3.5% net of inflation) or higher. From 1987 through September 2000, a flood of liquidity and our false perceptions were the primary drivers of low financial market volatility, low earnings volatility and low economic volatility (more low-quality MPT inputs).
Figure 7 alone disputes GaveKal's thesis. A great economic moderation was NEVER at hand. Absent their Brave New World, high asset valuations (credit & equities) collapsed when the liquidation of assets to repay debts began (August 2007).
There never was even a slight moderation in the excess EG over NGDP. The proof is in the monthly SD of EG-NGDP. From 1999 through March 2009, it was 4.11, which is nearly three times more volatile than the excess earnings over economic growth recorded from 1968 through 1999 (the old world). Old world economic and earnings volatility was much tamer than it was during GaveKal's Brave New World.
Estimating Future Returns And Investment Leaders
EG-NGDP helps us to estimate future equity and debt returns. It aids rotations to and from LQ to HQ securities. Since November 2008, it and other factors signaled a rotation to LQ assets. At the peaks and troughs of the EG-NGDP trend line (the blue line below), old market leaders die while new leaders are born.
Earnings Collapse
In the February and March InPerspective, we focused on the collapse of S&P 500 earnings from near $86 in the third quarter (Q3) of 2007. Last month showed an estimate near $16 by the 2009 Q2, which at that time was only 12.5% below the $18.29 estimate for all of 2008. The $16 estimate for 2009 Q2 now looks too optimistic. Figure 8 is from the April 6, 2009 issue of Barron's. It shows reported earnings at $14.88 for 2008 Q4, which is the first time they have published earnings below $28.75 since June 2003. The actual result posted at the S&P Internet site was -23.25 per share on April 9, 2009.
Estimates by Standard & Poor's for 2009 are still at $28.51, but given the huge misses since 2007, negative surprises are likely to continue in 2009. S&P estimates a negative P/E ratio of -467.52 by 2009 Q3, which is unprecedented on a 12-month basis.[i] This is so shocking that I almost copied it from their site verbatim below.
Our March InPerspective also saw the possibility of a deleveraged S&P price trough in the 219-607 range with a bottom no more than 12.5% below the 666.79 intraday low on March 6, 2009 (S&P price 587).
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