You Can't Go Broke Taking Profits

A common saying on Wall Street, and for good reason. Although the stock market has been acting very well in recent weeks and today's 200-point gain is a good start to this week, I am not going to be bashful about taking some chips off of the table for my clients and you shouldn't be either.

It is a contrarian move (not surprisingly, coming from me), as the market is breaking through upside support levels on a technical basis, but I want to have some cash on hand to make purchases during the next correction. When will that drop take place? I have no idea but it certainly will come. I would not be surprised if it was soon. After all, the S&P 500 has rallied from 666 in early March to 907 in early May, a gain of 36%. Still, we are up less than 1% for 2009.

Look For Swine Flu Related Opportunities

To me this swine flu outbreak looks a lot like avian bird flu; fairly contained and overhyped. Of course anything is possible, but as Wall Street frets about swine flu (Dow futures are down 150 this morning), investors should be on the lookout for investment opportunities. Worries over bird flu led to numerous bargains, especially in the poultry industry. We'll have to see what stocks, if any, are adversely affected by swine flu worries. Chances are they will excellent investment opportunities just as were available when SARS and bird flu were the worries of the day.

Q1 2009 Earnings Exceeding Estimates So Far

Are you surprised that the market is acting as well as it has lately, especially with earnings season having begun? Still waiting for that overbought correction after six weeks of gains in stocks? Me too. Why the relative strength? Well, according to Bespoke Investment Group first quarter earnings are coming in well above estimates so far (20% reporting):

"A fifth of the companies in the S&P 500 have reported earnings for the first quarter, and so far earnings are down 16.6% versus the first quarter of 2008. While down, this is much better than the -37.3% expected at the start of earnings season. When comparing actual earnings versus estimates, Consumer Discretionary, Financials, and Energy are leading the way. On the downside, the Industrial sector is the only one where actual earnings have come in weaker than expected. Earnings season still has a long way to go, but the fact that growth has come in better than expected thus far has been one factor driving the market higher."

How The Financials Are Greatly Masking the Market's Earnings Potential

Some people are making the case that the stock market can rally meaningfully even without the financial sector recovering. I disagree simply because earnings are being negatively impacted so severely by loan losses and mark to market writedowns at the large financial institutions that investors won't get a clear picture of what a reasonable expectation for S&P 500 earnings are until financial sector earnings at least stabilize, if not climb back toward breakeven.

Jeremy Siegel, well known Wharton finance professor and author of "Stocks for the Long Run" (an excellent book) had an opinion-editorial piece in the Wall Street Journal recently that was titled "The S&P 500 Gets Its Earnings Wrong" (subscription only) that made some interesting points about the currently depressed level of earnings for the S&P 500.

Dr. Siegel explains that while the S&P 500 is market value weighted (larger companies are weighted more heavily in the index than the smaller ones), Standard and Poor's does not use the same methodology when calculated the index's earnings. Instead, a dollar of profit from the smallest stock is treated the same as a dollar earned by the largest. As a result, the losses being accumulated by a small portion of the index are negating the profits being generated by the majority, which is making the S&P 500's earnings look overly depressed.

Consider the data below, taken from Siegel's column:

siegelstats.gif

Siegel is suggesting that the absolutely abysmal financial performance of the market's worst stocks last year (mostly from financial services firms, of course) is giving the appearance that corporate profits have absolutely fallen off a cliff in every area during this recession. He is quick to point out that 84% of the largest 500 public companies in the U.S. (420 out of 500) are actually doing quite well. That fact is going unnoticed because $1 of earnings from the smallest stock in the S&P is treated the same as $1 of earnings from the largest component, even though an investor in the S&P 500 owns 1,300 times more of the largest one than the smallest.

I'm not sure if Siegel is suggesting that they should actually go ahead and change the way they calculate S&P 500 earnings (and if so, I'm not sure I would even agree with him), but I do think this data is very helpful in seeing just how much the financial sector is masking corporate profits from other sectors.

My personal estimate right now for S&P 500 fair value is around 1,050 (14 to 15 times normalized earnings of between $70 and $80). I came up with those estimates before reading Siegel's article, but the data he provided give me comfort in the estimate. After all, if you assume the bottom 80 companies get back to breakeven and the other 420 companies maintain their 2008 profitability (both are conservative assumptions when the recession ends in my view), we see that S&P 500 earnings would range from $67 (if you use GAAP earnings) to $81 (if you use operating profits).

As you can see, any relief for the financial sector with respect to mark-to-market accounting principles could temper the writedowns going forward. Even getting the financial sector to breakeven by 2010 would reduce the negative earnings impact from the bottom 6% of the S&P 500, clearing the way for earnings to rebound pretty quickly from the $40-$50 level analysts are projecting for 2009.

Historical Data Disproves "Trough P/E Multiple on Trough Earnings" Myth

Doug Kass, a hedge fund manager dedicated to short selling and frequent guest on CNBC, made a call on the air Monday that the S&P 500 could make its lows for the year this week. A bold call indeed, given that Doug is a short seller and has been correctly bearish on the economy's prospects for a long time. His reasoning is mostly based on extreme pessimism (not unlike in November when we made a short-term low) and low valuations.

Other commentators debate the valuation point. CNBC's own Bob Pisani made the case that assigning a 7 or 8 P/E ratio (a typical number at bear market bottoms) to this year's depressed earnings level forecast (currently around $50 for the S&P 500) is reasonable. Pisani concluded that unless you think that earnings in 2009 will be substantially above $50 (which is very unlikely), the market is not cheap because 7 or 8 times $50 is 350-400 on the S&P 500 index, versus today's sub-700 level.

When Kass was on the air on Monday he rightly suggested that putting a trough P/E on trough earnings is not appropriate, but market commentators continue to insist that is where the market needs to go before a cyclical bottom can be put in.

I have argued against this logic on this blog before (sorry to keep harping on it), but I decided to dig up some evidence on this topic so perhaps we hear less of it in the future. Below you will find the earnings of the S&P 500 relative to the level of the index from 1970 through 1985, a time period that encompasses both the early 1970's recession and the early 1980's recession, both if which are similar in depth to what most believe will be our fate this time around.

peratioduringrecession.gif

From this data you can clearly see why everyone is using a trough P/E ratio of between 7 and 8 times earnings (the bear markets bottomed at a 7 P/E in 1974 and at 8 in 1981). The year of both market bottoms is in boldface to show these levels.

The key here is to look at the level of S&P 500 earnings during both 1974 and 1981. Although the stock market traded at the trough P/E ratios during those years, earnings were at record highs both times! The 1974 level of earnings ($9.35) had never been reached before. The same goes for 1981 earnings ($15.18). Therefore, the idea that we take trough earnings and apply trough P/E multiples is simply unfounded if we look at the very data people have supposedly been using.

Not surprisingly, I am far from the first person to point this out. John Hussman, former professor of economics and international finance at the University of Michigan, actually has created a more relevant P/E ratio called "price to peak earnings" which suggests that trough P/E ratios on previous peak levels of earnings are far more reliable bear market valuation tools.

Where would this type of P/E ratio peg the bottom of the current bear market? Well, S&P 500 earnings peaked at $87.72 back in 2006. Multiply that figure by 7.3 and 8.1 and you get a range for the bear market trough of between 640 and 710 on the S&P 500 index. Interestingly, especially given comments from Doug Kass predicting a possible yearly low this week, the index is in the 680's currently, which is right in the middle of that projected range.

Hopefully actual data is enough to debunk seemingly popular myths about bear market low valuations for the stock market. While this evidence does not make it impossible for the S&P 500 to dip to 400-500, it would make such a move unprecedented in terms of the last four decades of market history, during which we have seen two recessions that are proving to be very similar to this one.

Why Not Just Sell And Wait For Rosier Days?

I was emailing with a client yesterday and during the course of the conversation he asked the following:

"Are you overloaded these days? It seems to me that right now all we can do and should do is wait....there's still more downhill. I understand your investment philosophy does not concern itself with short term events, but still...shouldn't there be an exception if you have reasonable expectations that the market will sink more before it bounces?"

Since it is a good question, and one others may be wondering about, I thought I would elaborate here rather than just respond privately.

This client is right, I am not a market timer and do not base investment decisions on what the stock market may, or may not, do over the short term. If the market's short-term direction merely correlated with economic activity this would not be a wise philosophy. We would all simply sell our stocks when the recession began and wait until it ended before getting back into the market.

The reason why market timing is so difficult (and why I choose not to partake in it) is because the stock market is not a proxy for the economy over the short-term. The Dow didn't drop 300 points on Monday because the economy got worse, and the next time it goes up 300 points it will not be because the economy got better. There are so many crosscurrents that affect day-to-day stock market movements that it makes it very hard to guess which way things will go, even during a severe recession.

As an example, consider the last three months. If you asked economists and market watchers how the economy did over the last three months, there would be a consensus view that it has been bad and is getting worse. As a result, one might conclude that stocks would simply drift lower day after day, week after week, month after month, because there is no evidence that the economy is improving.

If we look at market data, however, we see that the S&P 500 rose by 27% between the lows made on November 21st (741) to the highs made on January 6th (943). Did the economy improve during that time? No, it got worse.

Since January 6th the S&P 500 has dropped from 943 to 700, a loss of 26%. What explains this move down? A bad economy? Probably not entirely, given that it has been bad the entire time despite two dramatic (and equally substantial) market moves in opposite directions.

We could make a list of at least a dozen reasons why the market rose 27% over a six week period, only to fall 26% over the next eight. All of those factors combined determine the short-term movements in the market and personally, I find them oftentimes irrational and highly difficult to predict.

To further illustrate the point that markets and economies don't always move in tandem, consider the last recessionary period of this magnitude that our country faced, 1980-1982. Look at how the stock market fared during this three-year period compared with key economic figures such as GDP growth and unemployment:

1980to1982data.png

Does the above data make any sense on its own? Not really. After all, the market rose significantly in the years the economy declined and fell during the year it rebounded temporarily. Joblessness rose consistently over the entire period. Simply assuming that the market will stay bad if the economy stays bad is too simpleminded for such a complex marketplace. There are so many variables that play into it, it could give you a headache trying to make sense of it all.

As a result, I choose to simply focus my time on researching individual companies, their long term prospects, and their share price valuations. There are plenty of people who prefer to focus on other things, and that's fine, that is what makes the market. We are all looking at the exact same data and still come to many different conclusions or choose to focus on different data points entirely.

As a long term investor, I am investing in a world where the stock market rises in any given year about 75% of the time. Not only that, but sometimes it goes up dramatically even when the economy sucks (as the data above shows). Over the long term, historical data has shown that there is a direct, inverse correlation between current share price valuation and future share price returns. Over the short term, stock prices are dictated by any number of factors and the near-term movements are anyone's guess quite frankly.

I prefer to stick to one aspect of stock market analysis. That is just my preference, it doesn't make it right or wrong, it's just what I am good at and have confidence in. Other market participants prefer to ignore the things I look at and focus on those that I ignore. Thank goodness for that, because without that discord, there would be no market for us to participate in, and it certainly would not be inefficient enough to present compelling investment opportunities for all of us to try and profit from.

Why Fair Value For The S&P 500 Is Not 440

Barry Ritholtz, market veteran and blogger over at The Big Picture postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.

Personally, I expect more from Barry given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don't know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index's components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.

Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a business person interested in buying your store. What would your reaction be if this person took your store's profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits. Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!

The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.

The second issue with Barry's analysis is the use of "as-reported" GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock's value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don't really play a role in fair value estimations.

The interesting thing is that you don't have to take my word for it on this topic if you don't want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.

Economy Continues to Deteriorate, But Stock Market Treads Water

Market strategists call it a "bottoming process" or "building a base." The chart below shows the S&P 500 over the last three months and you can see what they are talking about. Earnings estimates keep dropping, job cuts keep pushing up the unemployment rate, GDP continues to contract, but the S&P has been going sideways in a range between 750 and 950, even in the face of three months of bad news. No rally has been sustainable, but the market isn't getting significantly worse.

spx3monthsfeb3.gif

Some think this trend is a good thing, others would like to see the market rising in the face of bad news, but it is too early for the latter. There is no doubt that it is a positive sign that the market seems to have come to grips with the reality that job losses will continue, corporate profits in 2009 will stink, and the unemployment rate is headed well over 8% this year (from 7.2% currently). Since the market discounts future events ahead of time, current market prices appear to have priced in the consensus economic forecasts for 2009. Of course, we don't know if those assumptions will prove accurate or not. Only time will tell on that front.

For those looking for a large market advance, we likely won't get one that is sustainable until the economy shows signs of stabilizing. Just like stocks hit bottom before the economic statistics got worse, stocks will begin to rise before the economy begins to grow again, but we are likely facing months of stagnation before that happens. As a result, the last three months of sideways market action makes sense. Things might not get too much worse than most are expecting, but a recovery is going to take time.