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An interesting snippet from Mauldin's piece this week citing David Rosenberg of Merrill Lynch who has thus far had a great call on the economy. We'll see if he is right or not...
| quote: | Earnings and Mr. Bear
A theme in this letter for many years has been that over time markets of all descriptions revert to the mean. The classic definition of mean reversion is "the behavior of a variable in which the values for that variable move towards the long-run average value for that variable." Prices, indexes, and all types of economic variables tend to fluctuate around their long-term averages.
Profits as a percentage of nominal GDP is one of the more significant mean reversion examples. Last year we saw pre-tax profits as a percentage of nominal GDP climb to a 55-year high of 14%, which is really rather astounding. Why? Because over time, profits track nominal GDP. In the post-World War II era, nominal GDP growth has averaged 7.1%, while profit growth has averaged 7.4%. Profits over the long term as a percentage of GDP have not changed significantly for generations. Or put another way, profit growth has matched GDP growth. We will examine later what might happen if profits reverted to their long-term average (think ugly).
Now, in the short term, the difference between corporate profits and nominal GDP can vary wildly. But in the fullness of time, economic pressures will work to bring corporate profits back to the mean. This can come in the form of higher or lower wages, changes in productivity, higher or lower taxes, recessions, or growth booms. All of these and more affect corporate profits.
Let me give you one more way to look at it. If the economy is growing at 7% (nominal), then corporate profits cannot continue to grow for more than a few years at 15%. If that growth trend continued, then at some point in the future the entire GDP would consist of corporate profits, as each year the percentage of corporate profits in the GDP would increase. Since trees cannot grow to the sky, nor can corporate profits become larger than the economy, and so logic dictates that there will be an adjustment in the future. And we are beginning to see that logic play out. Let's look at a few numbers.
Trailing as-reported 12-month corporate profits on the S&P 500 peaked in the second quarter of 2007 at $84.95. In March of 2007, S&P forecast 2008 earnings would be $92. Then the economy began to run into trouble and S&P began to drop their 2008 forecasts, as the table below shows. (By the way, this is not to pick on S&P. Nearly every major forecast had similarly optimistic views.)
What actually happened? 2007 earnings actually came in at $66.18, following a lot of ugly write-offs in the last quarter. The estimate for 2008 is $72.01, as you can see above. Interestingly, they project lower earnings for 2009, down to $67.66. At today's closing price of 1257, that projects to a lofty price to earnings (P/E) ratio of 18.55, well above long-term averages and well above trend for periods of poor or no growth. For the record, there is no record in history of a bull market starting at a P/E of 18.
Earnings Before Bad Stuff
One other interesting statistic that caught my eye: Reported earnings are what you pay taxes on. They are what you really made. S&P also estimates operating earnings, or as I characterize them, Earnings Before Bad Stuff, or Earnings Before BS. There has been a lot of Bad Stuff of late. Operating earnings for 2007 were almost 25% higher than reported (real) earnings, and about 15% (so far) for 2008.
But the analysts at S&P must expect a lot of Bad Stuff in 2009, because they project a difference of almost 45% in 2009. Remember that they project real earnings to be $67.66 in 2009? Well, they project operating earnings to be a whopping $108.60. That will be a growth in earnings of almost 25% in 2009.
Before we get into whether such earnings growth is likely, think about an environment where company after company keeps reporting large write-downs every quarter. Of course, they will tell you it is just this once, so don't sell us - now is a buying opportunity. Long-time readers know that I have written on several occasions about how continuing earnings disappointments are what create a bear market. Typically it takes at least three to really get the attention of analysts and investors, who begin to lower their projections for both profits and price targets.
How Ugly Can it Get?
David Rosenberg, the North American Economist at Merrill Lynch, is one of my favorite analysts. He is a mainstream economist who is most definitely not a cheerleader. He can be quite bullish as times, and when he thinks the times call for it, he can be rather bearish. As we will see below, he is quite bearish of late. I am going to quote from his opening remarks in a commentary dated July 25, where he is changing his forecast. Remove sharp objects from your nearby vicinity.
"Forecast addendum: Adjusting to the new reality
"Just like consumers, who are insulating their windows and making fewer trips to the malls, we are adjusting our economic forecast to the new high-oil price reality not to mention the latest round of trauma in the mortgage markets. Though fiscal stimulus [rebate checks] will provide a lingering boost to 3Q we expect GDP to plummet 2.5% in 4Q and see a similar decline in 1Q. In all, we have shaved our 2009 GDP forecast to -0.5%, a full percentage point lower that where it was previously, while 2008 is broadly unchanged at 1.5%.
"Less consumer, more unemployment, profit squeeze ahead
"The scenario we ran last May, when we shocked the model with higher oil prices, now appears to be playing out as predicted. With rebate check delivery winding down, there is now little shielding the consumer from the full force of $4+ gasoline, deflating real estate and equity markets and rising unemployment. The new reality means a deeper downturn for consumers, higher headline inflation, more belt-tightening from businesses and a mammoth profit squeeze. It also keeps the odds squarely in favor of more rate cuts from the Fed, in our view.
"Back to the 1970s
"Once the last of the rebate money is spent, in either July or August, consumer spending is expected to roll over, and hard. The oil shock we're experiencing is on par with the spike in the mid-1970s and consumer spending will see a similar downturn, in our view. The unemployment rate will probably crest at about 7.0% in mid-2009, a half percentage point higher than our previous outlook. We're expecting a 3.0% decline in PCE in 4Q 2008 and 1Q 2009 does not promise to be much better. We look for savings to rise, as consumers adjust to the tighter credit environment by building their savings rate up to 2-3/4% by the end of 2009.
"2008 stimulus - round two?
"The deeply disappointing retail sales report this week only serves to underscore how far behind the curve consumer is financially and a grim foreshadow of what lies ahead once the rebate checks are all spent. Flat spending was all consumers could muster in July with three quarters of the $106 billion total rebate checks in their bank accounts. We take consolation from the notion that the folks in the Beltway are doing the same math we are and thus the drumbeat of another round of stimulus is getting louder all the time.
"Housing still in the weeds
"The good news is that we're probably more than half way through the real estate correction. The bad news is that we've likely still got at least another 15% down on home prices to go before we reach bottom. Moreover, housing starts still need to breach the 700,000 mark to deal with the mountain of new and existing homes with for-sale signs on them. The supply situation will not be helped by the latest fractures in the mortgage securitization market, which will only slow the pace that homes can be sold and inventories can be cleared."
Below is a table with some of his forecasts. You can read the whole report at http://www.realclearmarkets.com/The...2018%252008.pdf .
Can you say Muddle Through?
A Lean Mean Reversion Machine
Remember a few pages up when we were talking about the mean-reverting qualities of corporate earnings? If corporate earnings fell to their long-term average, that would mean a drop of about 50% from the peak, which would mean $45 in operating earnings, and even lower for reported earnings. You could easily see a P/E ratio north of 25 or 30 if the market did not move down. Quoting from another Rosenberg commentary:
"To put this into perspective, the four-quarter trailing EPS figure in the 2001 recession hit a trough of around $38; in the 1991 recession, the trough was just over $18. That means that we are not talking about Armageddon [projecting $45 earnings], but rather offering up some analysis highlighting the risks to the outlook. We will bottom at levels much higher than the troughs in the past; that is the good news. The not-so-good news is that the level of the S&P 500 in the past that tended to coincide with $45 earnings was right around the 1,000 mark; and if we were to slap on a typical trough multiple of 10-12x on that earnings stream, then ... well, you do the calculation."
I highlight this analysis because it illustrates the point I have been making for a long time. Recessions do ugly things to corporate bottom lines. They savage earnings, and that is what ultimately drives the stock market lower. For you to be bullish today, you have to believe that the recession is over and that earnings are going to rise, not fall.
A 15% drop from where we are today would not be out of historical character. It would be a merely average bear market in an average recession. Given the extremes to which profits rose in the last cycle, it would be strange indeed if they did not revert to the mean or go below. The Dow below 10,000 is not unrealistic, or the S&P below 1,000.
I clearly do not know the future, and the market does as much as possible to make me look bad. But I simply believe that the risk is to the downside. And if Rosenberg is anywhere near right, then it could get a lot worse. Continued earnings disappointments, combined with ever increasing write-offs implied by the S&P numbers, is not the environment for a renewal of the bull market. The current run-up is a bear market rally, in my opinion. It is a time to lighten up, if you have not already.
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