Thursday, February 14, 2008

Should We Love Equities?

Ah, Valentine's day. Lovers walk hand-in-hand in the park, early spring flowers bloom, birds sing sweetly in the air, and the greeting card and florist industries make money hand over fist. Macro Man's plans for the day are fairly modest- another trip to Croydon (hardly a center of romance!) to take care of some admin, and then a nice dinner at home with Mrs. Macro and a good bottle of wine.

Not that romance is dead, mind you. Macro Man is wondering how to manage another relationship, one which has occasionally yielded a bounty of joy but recently has turned distinctly frosty and distant. He refers, of course, to his relationship with equities.

Having remained broadly constructive on stocks through the end of last year, courtesy of the "muddle through" view on the US economy (which, depending on how you interpret the January retail sales data, was either strengthened or weakened yesterday), Macro Man was forced to abandon stocks last month, as the diastrous price action mandated a lovers' quarrel. His positioning ever since has retained a bearish tilt, or at least a tilt that has lost money this month- the large cap/small cap spread seems to drift lower no matter what the broad market does, and is rapidly approaching Macro Man's review level.

In any event, the apparent recovery in equities, combined with daily missives from a raging equity bull who holds forth on the culinary delights of bear steak, have encouraged Macro Man to at least review the premise of his bearish tilt.

As far as he can make out, the relationship between three things is currently skewed and will need to adjust. At this juncture it is too early to say in which way they'll shift, but he's confident that over the course of 2008 something will have to change. These three factors are the price of equities, the level of interest rates, and the expected level of corporate earnings in 2008.

In Macro Man's world, it's not that difficult to come up with a price forecast for the S&P 500. Figure out where you think earnings will be, come up with a multiple (which is at least partially driven by interest rates), multiply the two, and voila! There's your price target.

If we look at bottom-up earnings expectations for the SPX, the rationale behind the late 2007 swoon is fairly evident. Index-level earnings expectations were marked down from over 95 in the summer to 89 by the end of the year. The data has subsequently taken a jump, which Macro Man fears simply represents the turning of the calendar page from 2007 to 2008. (His usual datasource for this stuff is unavailable, so he's forced to back it out from Bloomberg data, which is about as elegant as Stone Age cutlery.) In any event, these figures appear to be confirmed by Standard and Poor's themselves, so Macro Man will take 97 as a reasonable level for current bottom-up estimated operating EPS.
Now obviously, bottom up estimates are generally overly optimistic, particularly early in the year. But that doesn't mean that they won't move the price of the index as they adjust througout 2008- just look at what happened last year! In any event, if SPX earnings really are 97 in 2008, then under most reasonable assumptions, the SPX is underpriced.

For most of the last couple of years, trailing P/E ratios for the SPX have averaged around 17. Put a 17 multiple on index level earnings of 97, and you get a year-end price target of 1649. Zowie! No wonder Macro Man's correspondent is so bullish! Now, it's obviously possible that multiples can shrink, and perhaps they will do so given the high levels of uncertainty over the economic cycle and the credit market. Yet with interest rates low and tumbling, the opportunity cost of not holding stocks is high and rising....assuming that underlying earnings don't plummet.

In any event, Macro Man constructed a simple "cheat sheet" to help him think about these things. The table below sets out the three variables mentioned above: index level earnings, assumed P/E ratio, and the resultant SPX price target. He rean simple scenarios for index level earnings ranging from 100 (modest upside surprise from current estimates) to 75 (earnings recession) and using two multiple assumptions- 17 and 14.
As you can see, the current price of the SPX is consistent with a modest earnings recession- a 10% decline in 2008 earnings vis-a-vis 2007, assuming a trailing multiple for the year of 17. What's interesting is that even if one assumes a more pronounced downdraft in earnings, you still only get to levels observed when the market was getting Kervieled.

So unless one is willing to forecast a bone-crushing recession or a multiple compression with low interest rates, which Macro Man presently is not, then one sort of has to conclude that equities are at least a bit on the cheap side....and perhaps quite a bit so. So does that mean that we should all fly back into equities for a lovers' reunion, spouting cliches about how "making up is the best part" of our relationship?

Not so fast. There remains considerable volatility around the current view, and just because Macro Man is not forecasting a recession now does not mean that he cannot contemplate doing so in the future. Moreover, while day-to-day price action is highly untrustworthy, we probably need to respect the underlying trend.
The chart above overays Wilder's Directional Movement Indicator onto the SPX. The cloud at the bottom of the page purports to show the underlying directional trend. You can probably guess for yourself that red equates to a bear market trend. Macro Man ran the same chart for the monthlies, and January saw the first reversion into a bear trend since 2003.

The current uptick may breach the trendline drawn, and may perhaps even breach the 1400 level that stopped the index a couple of weeks ago. But until the index can at leat start breaching some key moving averages, such as the 40 day shown on the chart, then all of this could just be a bear market rally. Until that is accomplished, Macro Man will probably follow the paraphrased advice of Stephen Stills: "if you can't be with the bull you love, love the bear you're with!"


Charles Butler said...

Nice piece. But I have to say I decamp with the lot that say you should include some calculation for slimmer margins in this mix, possibly putting a lid on upside profit expectations - recession or not. Wage inflation in manufacturing countries being the main culprit...

Anonymous said...


first, _operating_ earnings? - esp when there's a huge gaap (hehe) with reported...

second, even if you believe operating earnings, $97 is down from $101 two months ago, per charles, there's not only a lid, but a c-clamp around margins/profit expectations (unless you expect lots of inflation, at which point why assume low rates?); there's good reason markets are discounting a 10% decline -- bottom-up 'consensus' is just catching up...

third, as you noted, the credit/equity divergence probably isn't sustainable, so unless you think credit/housing dislocations are about to end, which i don't, then it should be resolved in credit's 'favor', cf.

Anonymous said...

long bond woke up with shotgun to its head.

Anonymous said...

a shot gun loaded with _inflation_

2and20 said...

I just don't get how you can be bullish on equities. The fundamentals could not be clearer. Individuals, companies and countries all have taken on too much debt. This leverage is now being unwound. For the case of companies and countries, this means pushing unemployment up. So individuals have less disposable income and will have increased defaults. Both of those will feed through into companies bottom lines, so banks have to write down assets, growth goes out the window, and companies move from growing their business to just trying to make their business survive.

So forget pricing in growth in the equity market. I would conservatively say that US corporates as a whole will easily see earnings down 20%, and P/E's getting pushed down to at least 12. Using your table, that gives me an S&P value of 900.

It's never been easier to make money in equities, just keep fading every rally. Trading individual stocks, just look for the sectors that will get hit first and hit hardest...banking, homebuilding, REIT's and retailers spring to mind. Plenty of good individual stock shorts out there in those sectors.

Macro Man said...

On an aggregate level, companies have not taken on too much debt and not overinvested in this cycle. That is an important factor.

It's also typical in an earnings downdraft to see multiples expand, as they did in the early Nineties and Noughties. But sure, one can forecast any mixture one wants. In extremis, one could put earnings at 50 and a multiple of 1, which gives an SPX price target of 50.

Anonymous said...


Thoughtful, as always.

My two cents: your cheatsheet assumptions are certainly reasonable in the short run. However, if we are looking a full year out, then I think we need to look at longer history as a baseline. 17 times operating earnings is not normal historically, and additionally the current earnings base is built on margins that aren't normal historically either. If these ratios "return to normal" the downside impact is quite high. As CB indicates a recession is not required.

Thank you for the fine blog.


Anantha said...

Your frequent consideration of dalliance with equities is, I presume, a consequence of the belief that the world economy would get by all right even if the financial sector stays in bed for a couple of years or longer.

Now, even if that were true, one cannot forget that the share of financial sector profits as a % of overall corporate profits in the USA has been at a historical high until 2q2007.

That was, as we know now, based on a lot of practices and degree of risk-taking, that is not going to return or, I hope, would not be allowed to return, by regulators at least in the very near future. Afterwards, memories fade and bad habits return in different forms.

If these assumptions are realistic, how sanguine one should be on prospective profit estimates for S&P 500 and what multiples one should attach to the profits of the non-financial corporate sector.

Alternatively, can the profitability of the non-financial corporate sector be restored to its pristine glory without a material weakness of the US dollar vis-a-vis the stubborn Chinese yuan?