If you think of where we are with the stock market, both of the following headlines could be printed accurately tomorrow.
1. S&P 500 down 23% over the last year, slump continues!
2. S&P 500 up 50% since March, looks overheated!
Now, most analysts like to talk about the second fact, because it is a bit more recent and certainly more dramatic. However the question that has to be answered is which one is more accurate.
If you look at various measures in the economy, it has contracted about 15%. That contraction may be reversing and there are two factors in valuation of a stock, earnings and growth.
When the economy started to contract and there were predictions of a possible new Great Depression, the earning did decline, but the very low valuations of March were based on the expectation of continued deterioration. I would argue this assumption was simply wrong and therefore those evaluations constituted a very poor valuation. Of course, it was an accurate valuation based on the sentiment at the time, and it enabled anyone who thought it was too low to make a very tidy profit.
So what about the valuation today? I still think it is a bit low, but not by as much obviously. Also, lets be realistic, there is still a lot of risk so P/E ratios need to be somewhat elevated. However, it is not too high.
I've been saying for awhile that I expect the S&P to hit 1200 this year and then trade in a range for the next few years probably between where it is now and 1200. the real easy money has probably been made and it is necessary to pick industries that will do well in a slow growth environment.
Showing posts with label S and P 500. Show all posts
Showing posts with label S and P 500. Show all posts
Sunday, August 16, 2009
Sunday, August 9, 2009
S and P valuation
I'd like to return to a theme I've addressed in prior posts and talk about the market valuation. Now, we have seen that interest rates have stayed low and for the 10 year treasuries are still below 4%. Since they are considered extremely safe investments they are a good starting point. If you are going to invest in a stock, you are taking on risk that simply doesn't exist in a treasury bond. Because of this risk, you probably want to get at least 50% more in earnings (not dividends but earnings) from a stock investment. So that would mean a return of about 6%, or a P/E of 16. Even if you use 15 instead of 16, this means that if you multiply the S&P earnings by 15 you should get an approximate valuation.
Now we have had a surprisingly good earnings season. Now as of Aug 4th, the current S&P estimate for 2009 and 2010 is 54.28 and 73.18 respectively. If you look at the current year estimate (and note the estimate shows earning increasing each quarter) you would come up with a market valuation in the low 800s. If you consider 2010 projected earnings you would get to about 1100.
Based on recent data, I believe there is sentiment that the earning may increase faster than the projections. After Friday's rally the S&P is just a little over 1000. If the market actually looks 6 months ahead, we would be about 20 points higher than the first quarter of 2010 estimate would indicate. Of course if you think the estimates are low, the market may be undervalued. However, since earning estimates are projected to go up each quarter in 2010, unless there is some specific bad news, I would expect the S&P to go up to 1061 next quarter.
A lot of commentators think the S&P has gone up to far and too fast and expect a pull back. The numbers don't support that position and in fact say the S&P is almost exactly where it should be. Now, if you don't believe the earnings or the estimates, that is a different story.
Which brings me to my next point. I hear commentator after commentator make a comment similar to the following :
"These earnings are due to cost reductions and are a one time event"
I think the people making these comments are intelligent but I simply can't figure out what they are trying to say. Cost reductions are not restructuring events, they are in fact ongoing. Once you eliminate cost and achieve earnings at a particular revenue level, you will continue to earn at that rate if the revenue level stays the same. Now if the revenue grows, you may or may not have to reintroduce cost and if we have any kind of recovery at all, I would think cost will be introduced at a lower rate than revenue will increase, leading to very good earnings growth.
I have heard some analysts say something that does make sense to me. Companies have used this downturn to eliminate jobs that they perceived to be of limited value. I believe many of the jobs cut will never be replaced, no matter how fast the economy grows, because companies will use this opportunity to either outsource them or replace them with automation.
I have discussed the need for the country to get behind the renewable energy growth engine to create jobs, but that is a different post.
Now we have had a surprisingly good earnings season. Now as of Aug 4th, the current S&P estimate for 2009 and 2010 is 54.28 and 73.18 respectively. If you look at the current year estimate (and note the estimate shows earning increasing each quarter) you would come up with a market valuation in the low 800s. If you consider 2010 projected earnings you would get to about 1100.
Based on recent data, I believe there is sentiment that the earning may increase faster than the projections. After Friday's rally the S&P is just a little over 1000. If the market actually looks 6 months ahead, we would be about 20 points higher than the first quarter of 2010 estimate would indicate. Of course if you think the estimates are low, the market may be undervalued. However, since earning estimates are projected to go up each quarter in 2010, unless there is some specific bad news, I would expect the S&P to go up to 1061 next quarter.
A lot of commentators think the S&P has gone up to far and too fast and expect a pull back. The numbers don't support that position and in fact say the S&P is almost exactly where it should be. Now, if you don't believe the earnings or the estimates, that is a different story.
Which brings me to my next point. I hear commentator after commentator make a comment similar to the following :
"These earnings are due to cost reductions and are a one time event"
I think the people making these comments are intelligent but I simply can't figure out what they are trying to say. Cost reductions are not restructuring events, they are in fact ongoing. Once you eliminate cost and achieve earnings at a particular revenue level, you will continue to earn at that rate if the revenue level stays the same. Now if the revenue grows, you may or may not have to reintroduce cost and if we have any kind of recovery at all, I would think cost will be introduced at a lower rate than revenue will increase, leading to very good earnings growth.
I have heard some analysts say something that does make sense to me. Companies have used this downturn to eliminate jobs that they perceived to be of limited value. I believe many of the jobs cut will never be replaced, no matter how fast the economy grows, because companies will use this opportunity to either outsource them or replace them with automation.
I have discussed the need for the country to get behind the renewable energy growth engine to create jobs, but that is a different post.
Thursday, July 16, 2009
The near term future
One of the things that is at the very least interesting is how short investor memories tend to be. After the March lows, we saw the Market climbed about 40%. In the beginning of June, we had a pause and a consolidation correction of about 5%. This type of pause is nearly inevitable since a certain number of investors are going to take profits, other investors don't want to buy at "inflated" prices and of course we always have our bearish friends who expect a total collapse at all times.
Now, many, many analysts predicted such a correction but as it was happening we sort of had panic in the streets. Even in the most persistent bull markets, there are pauses and dips along the way. Now when prices are going down and at the same time news comes out that disappoints a bit, such as the unemployment report, we have pundits ready to declare that everything is bad again and its probably time to buy lots of canned goods and dig a hole.
Naturally, the pause, consolidation, correction came to an end and with a bit of positive earnings reports the market rise has resumed. Now, based on my comparison to the early 70s and where I think earnings will be, I see a fairly rapid rise for the S&P to between 1100-1200. I don't think the economy is good enough to pass that level at this time and in fact, I would expect a bit of a correction near that level followed by a long period of range based training.
Now, my comparison to the 1970s and earning expectations are fairly speculative. I would say that once we get to the 1100 level, without a jump start we will see the market trade in a range of +/- 10%. The economy is still troubled and we need to get the next growth industry kicking in and we need to reform our tax system, or we face a fairly long period of stagflation, high unemployment and price increases.
Now, many, many analysts predicted such a correction but as it was happening we sort of had panic in the streets. Even in the most persistent bull markets, there are pauses and dips along the way. Now when prices are going down and at the same time news comes out that disappoints a bit, such as the unemployment report, we have pundits ready to declare that everything is bad again and its probably time to buy lots of canned goods and dig a hole.
Naturally, the pause, consolidation, correction came to an end and with a bit of positive earnings reports the market rise has resumed. Now, based on my comparison to the early 70s and where I think earnings will be, I see a fairly rapid rise for the S&P to between 1100-1200. I don't think the economy is good enough to pass that level at this time and in fact, I would expect a bit of a correction near that level followed by a long period of range based training.
Now, my comparison to the 1970s and earning expectations are fairly speculative. I would say that once we get to the 1100 level, without a jump start we will see the market trade in a range of +/- 10%. The economy is still troubled and we need to get the next growth industry kicking in and we need to reform our tax system, or we face a fairly long period of stagflation, high unemployment and price increases.
Thursday, July 9, 2009
Thoughts on earnings
Where is the stock market headed, or maybe a better question is what should the S&P 500 be trading at? Generally the level is closely related to earnings and as earnings for the 500 have dropped since last year so has the market valuation. However, we are now in earnings season and as companies make announcements, the S&P is going to react.
There are a number of historical charts on the relationship between the S&P level and earnings. Generally the price/earnings ratio needs to provide a yield that is better than what you can get in US Treasuries since realistically, why take a risk if you are going to get less money than you would for not taking a risk? Right now this would require returns of at least 5% but that isn't enough of a premium so generally I think 7-8% is a better gauge. At 7.5% you would trade at 13.3 times earnings. Generally $55 is the current estimate for 2009 so the S&P lower limit would be in the 730 range. Now if you are will to accept the 5% return with the hope of future growth, the P/E ratio changes to 20 and we get an S&P at 1100. A more normal P/E ratio tends to be about 17 so a reasonable estimate is 935.
Now of course the estimate for earnings and whether it should be earnings from operations or GAAP earnings, (includes all accounting write-offs and additions) is the starting point. I prefer earnings from operations, since if you start using gains and losses from asset valuations, and other accounting requirements, you add a lot of individual company variability. I think those things are important is assessing the long term well being of individual companies, but distort the overall comparisons too much. As an aside, all those asset write-offs due to property and inventory valuations, may now actually be hidden assets if the valuations have any upside.
However at a P/E of 17 the return is around 6% (5.88) and it is fairly safe to say that the market want to get at least the treasury rate of about 4% plus protection against inflation. So if you expect inflation to be 1% we are back to a P/E of 20, at 2% 17, at 3% 14 etc.
So level of earning with return on treasuries and inflation expectations can give you a good estimate of where the S&P should be.
Concerning earnings, while revenue is down for most of the S&P companies we have seen aggressive cost cutting and inventory reductions (look at unemployment and commodities). This is likely to show some earning improvement despite the fact that the level of activity is reduced. Two things should be considered. I think companies need to adjust to a reduce level of consumer spending. This doesn't mean they can't be profitable, simply that they need to be profitable at a lower level of sales.
Growth will return, but barring an unexpected surge in real estate prices, consumers simply don't have the ability to spend like they used to. We also know that ugly reality has hit the baby boomer generation and that the comfortable retirement they envisioned from the equity in their homes and the gains in the stock market have vanished. They are now saving more and spending less. I don't expect this to change. However, if GM for example can be profitable selling 2 million cars a year, is it a bad investment? It won't be as big as it once was, nor will it employ as many people, but it may still be a good investment.
So I expect that we will continue to see earnings beat expectations because of the cost reductions, not revenue growth. In fact I believe what we saw from Alcoa may not be far from the norm, where the aggressive cost cutting allowed them to beat expectations, admittedly still losing money, by 30%.
It may seem a bit contradictory, but the cyclical industries hardest hit by the recession have had the best opportunity to do drastic cost cutting.
How will the Market react? Initial reaction to the Alcoa earnings is positive. I would think that as earning continue to beat estimates we will see the S&P go to the 935 level and possibly approach 1000. However, the naysayers will talk about a sluggish recovery with little job growth and reduced consumer spending. True enough, but if we accept that the economy isn't going to return to 2007 levels, have we recalibrated sufficiently to grow from where we are?
There are a number of historical charts on the relationship between the S&P level and earnings. Generally the price/earnings ratio needs to provide a yield that is better than what you can get in US Treasuries since realistically, why take a risk if you are going to get less money than you would for not taking a risk? Right now this would require returns of at least 5% but that isn't enough of a premium so generally I think 7-8% is a better gauge. At 7.5% you would trade at 13.3 times earnings. Generally $55 is the current estimate for 2009 so the S&P lower limit would be in the 730 range. Now if you are will to accept the 5% return with the hope of future growth, the P/E ratio changes to 20 and we get an S&P at 1100. A more normal P/E ratio tends to be about 17 so a reasonable estimate is 935.
Now of course the estimate for earnings and whether it should be earnings from operations or GAAP earnings, (includes all accounting write-offs and additions) is the starting point. I prefer earnings from operations, since if you start using gains and losses from asset valuations, and other accounting requirements, you add a lot of individual company variability. I think those things are important is assessing the long term well being of individual companies, but distort the overall comparisons too much. As an aside, all those asset write-offs due to property and inventory valuations, may now actually be hidden assets if the valuations have any upside.
However at a P/E of 17 the return is around 6% (5.88) and it is fairly safe to say that the market want to get at least the treasury rate of about 4% plus protection against inflation. So if you expect inflation to be 1% we are back to a P/E of 20, at 2% 17, at 3% 14 etc.
So level of earning with return on treasuries and inflation expectations can give you a good estimate of where the S&P should be.
Concerning earnings, while revenue is down for most of the S&P companies we have seen aggressive cost cutting and inventory reductions (look at unemployment and commodities). This is likely to show some earning improvement despite the fact that the level of activity is reduced. Two things should be considered. I think companies need to adjust to a reduce level of consumer spending. This doesn't mean they can't be profitable, simply that they need to be profitable at a lower level of sales.
Growth will return, but barring an unexpected surge in real estate prices, consumers simply don't have the ability to spend like they used to. We also know that ugly reality has hit the baby boomer generation and that the comfortable retirement they envisioned from the equity in their homes and the gains in the stock market have vanished. They are now saving more and spending less. I don't expect this to change. However, if GM for example can be profitable selling 2 million cars a year, is it a bad investment? It won't be as big as it once was, nor will it employ as many people, but it may still be a good investment.
So I expect that we will continue to see earnings beat expectations because of the cost reductions, not revenue growth. In fact I believe what we saw from Alcoa may not be far from the norm, where the aggressive cost cutting allowed them to beat expectations, admittedly still losing money, by 30%.
It may seem a bit contradictory, but the cyclical industries hardest hit by the recession have had the best opportunity to do drastic cost cutting.
How will the Market react? Initial reaction to the Alcoa earnings is positive. I would think that as earning continue to beat estimates we will see the S&P go to the 935 level and possibly approach 1000. However, the naysayers will talk about a sluggish recovery with little job growth and reduced consumer spending. True enough, but if we accept that the economy isn't going to return to 2007 levels, have we recalibrated sufficiently to grow from where we are?
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