Market Thoughts

It seems that in honor of Halloween we see the stock market get scary.

The economy is doing fairly well but there are what is often called headwinds which might easily impact the future and the market is forward looking not concerned about the past.

We have the rising interest rates which will increase the cost of capital and the cost of carrying our national debt.  To some extent it also simply provides a safer place to put money with a better return for nervous investors.

You have the trade issues which are increasing the cost of goods and services and likely decreasing actual sales based on supply and demand.

If you add the prevailing idea that we are overdue for a correction or a recession, you have a pretty nervous market, in fact it always is to some extent.

Market movements gain momentum as the people who don't sell or buy at first look for ways to join in

Did something particularly bad happen to the economy?

Not really but we haven't had a recession in quite a while and with mid-terms about to happen we may simply be due.

Probably a good time to avoid risk until this comes to an end.

It might go on quite a while.

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.

Summer trading range

After an up week we are just about back to the levels in the Market we were in early June. I believe we are still defining the summer range and next week's earnings will determine if this is the top of the range or the middle.

If this is the top of the range than the market will retreat to about 875 in the next couple of weeks. If this is the middle we may go near 1000 before it retreats. I'm expecting earnings to mostly equal or beat estimates due to managerial efficiencies but top line revenue flat or possibly down some. There will of course be exceptions, but there is no great likelihood that consumer spending can resume at levels from the last few years.

The amount of consumer discretionary spending has remained relatively constant, even with layoffs as various social programs have kicked in but the loss in real estate equity is going to hinder spending for a considerable time period. Consumer credit is impacted by the fact that rising home values enabled many to tap the equity and it also made them feel more comfortable in using other credit since the housing wealth served as a safety net. With that safety net gone, the equity is no longer there to be tapped and other credit looks more ominous. Compounding the problem is the fact that with the loss of home equity there was a corresponding reduction in the value of many people's retirement savings. People are therefore saving more of their discretionary income.

So, as I've been saying consumer spending has to find a bottom. Now as there has been less spending and less lending, effectively the amount of money in circulation falls. Further we are establishing a new price expectation in many consumer areas. Prices of many products have been discounted for an extended period of time. While these discounts have been presented as "sale" prices they are so frequent that they are really becoming the "normal" prices. It would take a significant jump in demand to reverse that trend, and since I don't see a V shaped recovery in housing nor do I see a big increase coming in discretionary amounts for spending, where would this come from?

So short term, top line revenue will continue to disappoint and this will probably be interpreted in a bearish way. Of course, if you would like to see the economy return to the overheated levels of 2007 it is, but that would require a massive stimulus, properly directed that would inflate housing and prices and clearly lead to a new bubble.

So, while earnings will be decent and may beat expectations due to cost cutting, top line revenue will be flat and I expect the Market to react somewhat negatively in the next week or two.