Tuesday, December 18, 2007

How Low Can We Go?

Depending on who you listen to, the reasonable analyst expectations for 2008 S&P 500 operating earnings range from a modest +6% (typically top down approaches) to a very optimistic +14% (the ever optimistic bottom up numbers). In either case, the stock market is severely undervalued. However, let’s assume for a moment that operating earnings for 2008 hit more than a few rough patches thereby pushing earnings down some. Moreover, let’s also assume that longer term rates rise due to inflationary concerns and/or an easing of the flight to quality. That produces two questions:

* What is the reasonable valuation level for the market?
* How much lower (if at all) must the current stock market correction go before it is done?

If operating earnings were more seriously impacted thereby producing an earnings recession, a reasonable worse case scenario for operating earnings in 2008 might be $86. This is not implausible as some operating earnings expectations for Consumer Discretionary are a very robust (insane might be a better term) +15 to 20%. Moreover, the effects of the housing bust and credit squeeze may impact sectors such Financials more dramatically than currently anticipated.

Now, let’s put a little more uncertainty into the mix and say that longer term rates, such as the 10 year US Treasury, rise, oh, ½%. The rate increase may be a result of inflationary concerns and/or an easing of the flight to quality as the global central actions to address the credit squeeze works to a degree thereby alleviating some of the fear built into the current flight to quality in the credit markets.

Incorporating the $86 number and a 10 year US Treasury rate of 4.75% into my Expected Return Valuation Model* produces a potential low point for the S&P 500 of 1360. That said, the final question becomes when?

Investment Strategy Implications

Given the high degree of current market pessimism and the fact that we are just weeks away from the January effect, the likelihood is that the market might begin its slump to 1360 (7.4% decline from yesterday’s close) sometime around mid January. Until then, staying fully invested seems prudent. Moreover, during the next four weeks, trading opportunities (Lunch Money) should present themselves.

Note: The above worse case scenario produces a target range for the S&P 500 of 1496 to 1550. At those levels, the minimum market return from yesterday’s close is an average +1.88 to 5.56%.

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