excerpt from this week's report*:
"The traditional method of fundamental analysis implies a market that is substantially undervalued. Even under a strong recessionary scenario of 12.5 times $72 (= 900), the current S&P 500 price produces a positive return. Only a deflationary scenario puts the current market level at overvalued."
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excerpts from this week's report*:
Technical Analysis
"Last week’s market performance pushed the Moving Averages Scorecard to its worst level thus far, at 16.67% bullish. A potential key reversal might be forming in the Financials but there is still considerable work to be done before such a call can be made with any confidence."
Valuation Models
"Next week, I will begin providing a scenario range for each of the economic scenarios listed below (see report*). This will follow along the lines of the top-down earnings scenario published in prior reports. This should help quantify the probable economic outcomes from an economic scenario perspective."
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excerpts from this week's report:
Model Growth Portfolio
"The underweight in Healthcare and the good results from Mid and Small cap growth as well as the EAFE growth helped produce the good weekly relative performance results.
Last week's relative performance pushed the year-to-date results back up over 300 basis points to 327 over the market..."
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commentary from this week's "Sector and Styles Strategy Report*:
Back on February 11th I wrote a report titled “What are the Sell Side Analysts Smoking?” The commentary and report focused on the excessively optimistic outlook earnings forecasts for 2008 by bottom-up analysts. Excessively optimistic in that top-down forecasts were substantially below the bottom-up numbers.
At the time, the bottom-up crew projected operating earnings for the S&P 500 for 2008 was an astounding +24% over 2007’s numbers ($102 versus $82.54). Whereas, the top-down forecasts had operating earnings for 2008 in mid $80s on down to the mid $70s.
Since then, particularly over the past two months, the bottom-up forecasts have gradually ground down to reality so much so that they have now reached the slightly negative territory of -2.4% (see Earnings Outlook on page 3 of the report*). One might therefore conclude that for 2009 the bottom-up boys and girls would factor in more of the data and analysis from the top down crowd but that is just not the case. For 2009, the numbers are equally, if not more, astounding.
According to the recent consensus forecasts, bottom-up earnings growth expectations for 2009 is a whopping +26%! Even after you exclude Financials you still end up with a +13.3% number. Excluding Financials and Energy gets you to 13.8%. And, lest you think that this dream state is restricted to the US, think again. The global numbers are a cool +18.7%, up from 2.8% currently projected for 2008.
Where does this thinking come from? How do you get such optimistic numbers when most top-down forecasts (from economists and investment strategists, often in the very same firms!) are much like this year – closer to 0%.
I believe a major part of the problem lies in the process by which bottom-up analysts go about making their forecasts. Specifically, when it comes to making earnings forecasts, many if not most bottom up analysts have a “silo” mentality, often acting as though there were no interconnections between their defined industries and companies and the broader macro climate. To be more specific on this point, I am not talking about your basic, tradition GDP starting point but rather the thematic and trend issues that are often hard to quantify such as the credit crisis and the risk of contagion therefrom.
Investment Strategy Implications
There is no news in stating that there are many risks facing investors as the last leg of 2008 unfolds and 2009 comes closer into view. Yet, what seems to be news to many bottom-up analysts is the interconnectedness and impacts from thematic and global macro trend issues.
Therefore, for the benefit of those who insist on using bottom-up forecasts exclusively, let me offer that the great risk for 2009 is the one I have written about time and again – credit related losses that move UP and OUT: UP the quality spectrum (within an asset group) and OUT to other asset groups, such as credit cards, student loans, auto loans, and corporate debt.
This danger is tied to the economic pain that results from deleveraging, with deleveraging not restricted to the banking industry but to the US consumer as he/she comes to terms with the consequences of a negative wealth effect and the need to repair their seriously overleveraged balance sheet. The result would be more savings, less spending, an extended period of subpar growth, and a transformation of the US and world economy away from its high dependency on US consumption.
Reliance on the traditional and the standard methodologies during times of economic transformation and change can and almost certainly will lead to faulty projections that can be very expensive.
*Published Aug. 25, 2008. Subscription required. For more information, click here
excerpt from this week's report*:
"Back on February 11th I wrote a report titled “What are the Sell Side Analysts Smoking?” The commentary and report focused on the excessively optimistic outlook earnings forecasts for 2008 by bottom up analysts. Excessively optimistic in that top down forecasts were substantially below the bottom up numbers..."
*Published Aug. 25, 2008. Subscription required. For more information, click here
commentary from this week’s “Sectors and Styles Strategy Report”*:
Unless one buys into the idea implied by the recent price action of US consumer related sectors (see pages 4 and 8*) that economic matters in the US are about to get much better, the only reasonable conclusion one can reach re the recent market action is the hedge fund dominated action of rotational trading. A scramble for alpha in alpha starved environment (for most hedge funds, specifically) appears to be clearly underway.
As noted on numerous occasions and described at my recent NYSSA Market Forecast event, the current equity markets are overwhelmed by short term hedge fund traders with a near non existence from the more traditional investors. For what else can explain the surge and purge nature of the market action overall. Or the recent fascination with the second least attractive sector – Consumer Discretionary?
At the same time, the current US dollar rally (see chart on next page*) has encouraged fence sitters to take the plunge into US assets.
And while the dollar rally may have more strength left in it, the difficulties that the US will face in the coming years should give longer-term investors pause before completely buying into the strong dollar scenario.
Investment Strategy Implications
Just like cyclical corrections in secular bull markets, counter trend moves in bear markets are common. And can be quite productivity played if one is nimble. Combined with the recently oversold Financials sectors (which provides an alleviation of the pressure on the market overall) and strong undervaluation for equities (see next page for several thoughts on this matter*), the reasoning behind a fully invested position for the time being seems warranted.
Nevertheless, as noted in last Thursday’s Minyanville blog posting, this is a game of chicken with one of the signs to keep a watch out for is a return to form, especially in areas such as Consumer Discretionary and Financials.
*Published Aug. 18, 2008. Subscription required. For more information, click here
excerpt from this week's Sectors and Styles Strategy Report*:
"Last week’s tepid US market action belied the much stronger decline in global markets (see page 8 of the report). Additionally, emergent strength in US consumer related sectors was evident. The combination of the two was modestly offset by the exceptional performance in the Small Cap growth position. Nevertheless, the MGP produced a slight negative alpha of 10 basis points**, aided also by the pricing difference between the cumulative results of the economic sectors (+0.52%) versus the S&P 500 (+0.15%)..."
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**For longer-term performance data, see the charts to your left.
“Of all the newfangled financial creations that have caused problems this past year, arguably the most nerve-wracking are derivatives traded over-the-counter…”
Economist
August 8, 2008
And the beat goes on.
On several occasions over the past year, hopes rose that the credit crisis was about to abate only to be dashed by yet another set of surprisingly large bank write-downs. Surprising to some but not on these pages. The risks from the credit crisis are far broader than originally thought and only now becoming grudgingly clear. And there is truly no end in sight.
UP and OUT is my way of characterizing what Nouriel Roubini has accurately described as the full scope of the financial Frankensteins created over the past decade. UP in the form of write-downs moving up the quality spectrum within an asset group. And OUT to other financial instruments created by the wizards of Wall Street.
Exacerbating the situation is the (efficient market hypothesis inspired) accounting rule change instituted last November, FAS 157, in which assets impacted by diminished demand produce lower values requiring mark-to-market write-downs thereby requiring new capital to meet banking related capital requirements leading to further pressure across the entire banking system. A vicious circle.
The equity markets are beset with multiple layers of issues – some, such as inflation, likely to not be an issue for much longer. However, fears of a global economic slowdown are now more real than ever, particularly when we get to 2009 and corporate default rates begin to rise as noted in the following chart* from last week’s NYSSA Market Forecast event (courtesy high yield expert Marty Fridson):
Moreover, according to Marty, the peak isn’t projected until 2010 at an 11% rate. This is the origin/catalyst of the $250 billion (net) credit default swap pain noted by PIMCO’s Bill Gross back in January of this year. So, if you want to see how banking losses get into the $1 to 2 trillion range, this is one contributing component.
Investment Strategy Implications
Last week’s so-called “Olympian rally” in equities must be taken with a huge grain of salt. As noted in several areas of this report*, the contradictory nature of the recent market rally is hardly the stuff of sustainability. Highly fragmented market action with little to no sustained and coordinated leadership provides no real investment comfort beyond riding the bear rally from its undervalued levels.
Until there is more market structure, an overall market neutral approach is advisable to take. Scalping “lunch money” trades is also a good short-term course of action for a modest amount of money. However, given the looming danger of a no-end-in-sight credit crisis and a 2009 that may stress test more than the banking system, the deleveraging process on multiple levels (banking, US consumer) warrants an above average level of caution.
*see report. For subscription information, click on the newsletter link to your left.
excerpt from this week's report:
"No doubt, last week’s $14.3 billion surge in consumer credit will help the US economy in the near term, but eventually US consumers must begin to repair their debt laden balance sheets. At noted in my Thursday blog posting, until consumer expectations re their assets (real estate and financial) may not deliver their future needs (notably retirement), consumers live in denial and balance sheet repair (in the form of reduced borrowing and increased savings – from income) is deferred. This is a question of when not if..."
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excerpts from this week's "Sectors and Styles Strategy Report" commentary (published yesterday):
idiom: Betwixt and Between
“neither the one nor the other; in a middle or unresolved position”
The past ten days have seen a drift in US equities with a certain amount of sector turmoil, mostly Financials up and Energy down (see first chart, with Utilities the biggest loser). From a size perspective, the bear rally produced the beta trade with Micro and Small cap doing exceptional well (second chart).
While the bear rally has produced a respite from the well publicized (and I would argue near term overplayed) angst emanating from the twin disasters of banking losses and high energy prices, the far more important stagflation lite with “no end in sight” for both bank losses and housing (which are becoming mutually exclusive) looms large in the 2009 background.
In the meantime, for the remainder of this year the top-down derived $82 operating earnings for 2008 for the S&P 500 seems more and more on target as the bottom up analysts slowing come to grips with reality (see page 3*).
Absent a meaningful catalyst, it is hard to see how leaning one way or the other at this time makes strong investment sense. Marking time and exploiting what little super short term trading opportunities might present themselves may be the best approach as the dog days of summer roll on.
Investment Strategy Implications
The idiom “betwixt and between” seems most apt for the current economic and investment climate suggesting the market neutral position I noted in last Thursday’s blog posting. No doubt time will present the next “great” investment idea. Until then, forcing the issue seems destined to destroy alpha.
*see report. For subscription information, click on the newsletter link to your left.
excerpts from this week’s report:
Model Growth Portfolio (MGP)
“With the exception of Biotech’s +13 basis points, very little market movement produced fairly quiet price action resulting in a +3 basis point week…”
Expected Return Valuation Model
“The continuing struggle between the risk adjustment process (dark blue zone) and the projected 12% fair value levels (grey zone) at $82. What argues in favor of the latter is…”
Moving Averages Scorecard
“After week’s teetering on the edge, Utilities’ mega trend finally turned bearish leaving Energy as the sole US economic sector on the plus side. Utilities, viewed by some as…”
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commentary from this week’s “Sectors and Styles Strategy Report”*:
In economic life as in the game of Monopoly, what you buy determines how large your pool of assets will be. If the Republicans are advocates of the high life, then the Democrats are more pedestrian in their interests. Consider the need for public works programs in the US.
Regardless who wins the White House, the crumbling infrastructure in the US will almost certainly receive considerable focus and funds beginning next year.
There are two reasons that should drive this initiative. First, the need is clearly there. Years of neglect and priorities elsewhere (Iraq, for example) have produced a pent up need to fix bridges, roads, and water facilities (see today’s C-Span program on water infrastructure issues). The second reason for the initiative will likely come from the need to offset the second down wave in the US economy with bank losses exacerbating the circumstances. Moreover, should such a second down leg occur, it is highly likely that the global economy will get sucked along in the slide as emerging market economies must begin to come to terms with their own inflationary difficulties thereby necessitating a serious increase in monetary restraint.
Investment Strategy Implications
The US Congress is likely to push through another consumer-focused rebate before election time this year. However, past that point the need to address the neglected infrastructure will be both necessary and politically useful.
The necessary part is self-evident. The political dynamic is also apparent when you consider that the longer lead time for infrastructure spending programs (versus consumer directed initiatives) dovetails perfectly into the election cycle as the benefits for programs begun in 2009 will begin to be felt most strongly in 2010 – a mid term election year.
As noted a few reports ago, infrastructure spending worldwide is projected to be $41 trillion (2005 to 2030). Added to this is the vision put forth by Al Gore re renewable energy and the companies playing in the infrastructure space are in the secular sweet spot.
As for the MGP, in addition to building on the modest position established in ..., I am considering the .... Will advise on this shortly.
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excerpts from this week’s report:
Model Growth Portfolio (MGP)
“Last week’s modest decline in relative performance moved the year-to-date results off its high to 346 basis points over the S&P 500…”
Expected Return Valuation Model
“While risk expectations declined last week with the VIX dropping below 23, it does seem more realistic to consider the prospects of a P/E ratio around 17 versus the BMR forecasted 19.2. Given the likelihood that a further weakening global economy, uncomfortably high inflation, and the prospects for the second wave of bank losses, a move toward…”
Moving Averages Scorecard
“While last week’s market action produced a standoff in the bottom line mega trend reading at the still fairly bleak at 29.17%, most indices moved more toward the negative side of the equation. Notably is the drop to bearish for Emerging Markets (EEM). Moreover, unless markets rally quite significantly or at least stabilize, the negative readings will likely increase pushing nearly all indices into bearish territory…”
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commentary from this week’s “Sectors and Styles Strategy Report”*:
The Democrats in Congress appear poised to exercise the political version of the second coming with a second coming of their own – a stimulus package targeted toward consumers for the last half of this year: the election half.
The number bandied about is $50 billion. Just enough to look busy, yet not quite enough to enhance the presidential chances of Senator McCain. After all, the Democratic equation is McCain = Bush third term. Certainly the Democrats can’t disrupt that math.
There are two aspects to this issue:
First, a clearly defined pattern has emerged, as stopgap measures seem to be rage in government. Be it the financial wildfire strategies of Paulson and Bernanke or the rebate checks or offshore drilling or ad hoc regulatory actions, seriously thought out solutions to long-term problems are clearly not a part of this most political of years.
Second, $50 billion, while hardly enough to be truly meaningful, will likely be just enough to help the US economy avoid a full blown recession this year. In the process, the full year operating earnings for corporations will likely be a touch higher than the top down projections of $82.
Investment Strategy Implications
If the operating earnings number for the S&P 500 for 2008 were moved up a touch from $82, and given the fact that the market is presently so sufficiently undervalued (assuming one does not buy into the stagflation lite scenario) then stocks should continue their summer rebound with or without Financials leading the parade.
In regards to Financials, it does seem that any economic performance that produces bad but not terrible results will be most welcome. Some semblance of stability may not produce much in way of stock gains for the group (contrary to what many bottom fishing investors might hope for), but it would go a long way toward to providing an overall sense of relief that the end of world is not just around the corner.
As for solutions to long-term problems, that clearly is not on the agenda for this year. Once it does become the focus of public policy, I would suspect issues like infrastructure building will take precedence over consumer demand stimulus packages. And in doing so, a secular uptrend in that area will produce very attractive investment opportunities for years to come.
While busy work is not truly productive work, a few sorely needed bucks (for consumers and investors) will not be rejected.
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excerpts from this week’s report:
Model Growth Portfolio (MGP)
“Wow. A fantastic week as the strong underweight in Energy finally paid big dividends producing most of the relative performance gains at 63 basis points. Combined with a modest 13 basis points and no major negatives produced one of the best weekly performance for the MGP (+114 basis points) in its three year history…”
ETF Market Monitor
Econ. Sectors & Industries: “The collapse in Energy along with satisfactory results from key financial institutions generated a role reversal, at least for one week.
Size & Styles: Small caps, particularly Small Cap Value, Micro Cap, and Transports all had a stellar week.
Global: Most global markets did not join the US parade. Energy sensitive countries such as Canada and Brazil faltered.
Other: Along with Oil, Commodities were sharply lower.”
Expected Return Valuation Model
“The rise in the 10 year yield this past week coupled with the modest increase in equity levels reduced the severe undervalued readings. Nevertheless, stocks remain substantially undervalued. (It is also worth noting that the VIX dropped below 25, thereby justifying, for the moment, maintaining the 100 to 120 basis point risk premium – yellow zone.)…”
Moving Averages Scorecard
“Last week’s rally produced some relief for most indices as their near term direction improved. Most notable were the step up from extended (on the downside) to Intact for Consumer Discretionary, Financials, Industrials, Mega Cap, and Large Cap…”
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commentary from this week’s “Sectors and Styles Strategy Report”*:
Sunday evening’s US Treasury and Fed actions may seem bold to some. I beg to differ. Here are a few thoughts for your consideration:
A recent report from respected consultancy Bridgewater Associates upped the ante of banking losses to a whopping $1.6 trillion. In consideration of the fact that only ¼ of that number, $400 billion, has been write-off/down thus far was more than enough reason for investors to buy into the panicky feeling experienced these past weeks. For those who like I subscribe to Soros’ reflexivity thesis, the feedback loop to the real economy via a deleveraging contraction is the single most dangerous consequence of the credit crisis (even if the bank loss number is closer to IMF’s $945 billion figure).
As if that weren’t enough, the oil price crisis, with its worldwide inflationary consequences for all countries, is generating demand destruction in developed countries. Here, too, a feedback loop to developing countries presents yet another dangerous outcome to the world economy. Decoupling goes only so far.
These past few weeks, the twin negative forces are being manifested in fear among investors as the valuation inputs from declining earnings and high inflation are producing a dangerous cocktail of lower P/Es and declining earnings that may bring about a stock market decline befitting a super bear.
Investment Strategy Implications
Incrementalism is a product of a belief that what is in place will work. Yes, there may be pain but the tools at hand are the tools that will produce the good result in the end. In the case of the governmental powers that be, that belief is market fundamentalism. This is at the heart of the problem and difficulty in reaching sustainable financial and economic solutions. As long as the Treasury, the Fed, the Administration, and the Congress operate under the rules of market fundamentalism, the actions taken will be like baby steps (such as the Bear Stearns and now the Fannie and Freddie bailouts as well as the Term Facilities to commercial and investment banks) when more serious, more comprehensive, more activist solutions are required.
But let me not restate last Thursday’s blog posting and point to the general market consequences that declining earnings and high inflation will produce.
The following rather simple table provides the P/E levels investors might contemplate should earnings experience even a moderately bad decline from last year’s $82.54:
Does the market fully understand and anticipate such a scenario? I doubt it. More likely shorter-term factors are moving the markets as the dominance by momentum-playing hedge funds produce surges and plunges (mostly the latter of late). Nevertheless, the numbers noted in the above table must not be ignored as its outcome seems more likely the longer market fundamentalism ideology results in baby steps.
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excerpts from this week’s report:
Model Growth Portfolio (MGP)
“A strong relative performance recovery due to the aforementioned strong underweight in Energy and moderate underweight in Financials along with the absolute positive performance in the Smid growth positions lifted the year to date results to a positive 257 basis points…”
Model Growth Portfolio (MGP) Re-balancing
“One minor portfolio change and one reclassification are being recommended...”
ETF Market Monitor
Econ. Sectors & Industries: Financials were hammered while Healthcare and domestic Consumer Staples and Utilities excelled. Steel also rebounded strongly.
Size & Styles: The Smids (including Micro Cap) and Dow Transports painted a much brighter picture than the S&P 500.
Global: Many global markets tracked the dismal US. However, China, Malaysia, and Singapore did not.
Other: : Commodities did not follow Gold’s good performance.
Expected Return Valuation Model
“A justifiable argument can be made to raise the risk adjustment factor (concurrently lowering the projected P/E ranges) as the real risk of declining earnings occurring next year are now being heard with greater intensity. The stagflation lite scenario. I will hold back on making this change for the moment pending the US government’s action…”
Moving Averages Scorecard
“Further deterioration pushing the total mega trend number to its lowest reading thus far. The one bright spot is the improving near term trend in China…”
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commentary from this week’s “Sectors and Styles Strategy Report”*:
“So let it be written. So let it be done.”
Pharaoh
The Ten Commandments
Labeling, such as equities are now in a bear market, seems to have taken on a meaning that transcends reasoning and analysis and has settled into the domain of dogma. In other words, is there any real, analytical significance to the fact that certain indices have declined to such a point that they have produced a decline of 20% or more?
To some, the bear market bell has rung and, therefore, stocks are now banished to a land of expanding declines to all segments and sectors, as evidenced by last week’s thrashing of the leadership issues. Stocks destined for more losses is the given. But is it so that because some arbitrary line in the sand (down 20%) has been breached further and more extensive declines are a fait accompli?
Moreover, is it a done deal that equities are headed for sustained bad times when other important indices, such as the Dow Transports or the S&P 400 Mid Cap have declined to a meaningfully lesser degree?
To be sure, there are those who would argue that the all-knowing market has a "wisdom" that mere mortal investors would be reckless to challenge. Yet, here too, dogma supplants analysis and reasoning. For example, as noted in previous reports and blog postings, the current equity market climate is dominated by the shorter-term players (hedgies), whose time horizon ranges between milliseconds and weeks. Therefore, can it be assumed that the "wisdom" of the market resides with those whose interests are less oriented toward fair value analysis and more oriented toward what will produce the best short term results?
Investment Strategy Implications
There appears to be two ways to interpret current equity market sentiment. One is to say that stocks have crossed a line that now dooms future market action to much lower levels, with a broadening out of the pain to all sectors, styles, and regions. No place to hide. The current decline is the second leg of the bear and any near term rallies should be treated as selling opportunities.
The real economy underpinnings to this conclusion are numerous, everything from stagflation to $1.6 trillion in bank losses to $200 a barrel for oil and a global recession. Of course, such serious economic problems assume a static rather than dynamic environment. A cause and effect that lacks responses and their feedback effects that could alter the pre-destined outcome.
There is a real danger in buying into the dogma of benchmarks. As someone who believes more economic and investment pain lies ahead, it is hard to agree, however, with the thinking that it will all come to pass now that we have passed some magical, yet dreadful, line. Therefore, an alternate conclusion might be that the aforementioned real economy horrors will be forestalled for a variety of reasons, such as the $1.6 trillion bank losses is shrunk thanks to intellectual sanity rebuffing FAS 157 and the fair value doctrine. Or that $200 oil does not occur as the demand destruction that $140 oil produces caps further rises. Or perhaps oil declines to $100 as regulatory and legislative action force full disclosure of ownership interests in commodities (see yesterday's WSJ online article re pressure on the CFTC).
Timing is everything, it is said. And the timing of a large drop in equities seems more appropriate for a later date, more like the first half of 2009.
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excerpts from this week’s report:
Model Growth Portfolio (MGP)
“Not even the strong underweight in Energy (producing a positive 28 basis points could offset the combination of poor results in the size & styles and global markets plus the occasional pricing distortion between the S&P 500 (-1.21%) and the economic sectors (-1.67%)…”
Model Growth Portfolio (MGP) Re-balancing
“No position changes are being recommended at this time...”
ETF Market Monitor
Econ. Sectors & Industries: The strong performers were finally hit big with Steel the biggest weekly loser tracked followed by Homebuilders. Biotech stood out on the plus side.
Size & Styles: The same story, strong giving way, was evident in this grouping as the Smids declined dramatically.
Global: Heavy losses across the entire spectrum (except the UK, which came off a very low prior week ending number).
Other: Gold and Commodities produced solid weekly results.
Expected Return Valuation Model
“One the significant values in running a valuation model is that it forces you into challenging the assumptions built into the model. In the case of the ERVM, some of the issues that must be resolved us whether projected operating earnings are accurate? In this regard, the much more conservative number reached via a top down scenario method does not appear to be out of line, especially when compared to the bottom up numbers forecast by…”
Moving Averages Scorecard
“Most of the damage was done in the prior week with last week’s action merely producing some near term deteriorating but no changes in the mega trends. Basic Materials, a market leader for several years, gave up considerable ground these past few weeks but has not produced a mega trend change thus far, as the following chart shows…”
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commentary from this week’s “Sectors and Styles Strategy Report”*:
Recently. there has been a fair amount of talk re stagflation and its consequences, both economic and equity valuation. Should the experience in the coming years resemble the stagflationary era of the 1970s, then P/E levels are more than justified to crumble to single digit levels, as they did then.
Dismissing the stagflation threat entirely would be a mistake. Yet, buying into the idea that a 1970s style stagflation environment is in the current economic cards appears to be equally suspect as the world economy are clearly changed considerably since then. There is, however, a stagflationary scenario that does bear serious consideration – stagflation lite.
In a stagflation lite environment, growth stalls like it did in the 1970s but inflation rises at a much more modest degree. In such an environment, the economic impact is obviously more muted, this thanks to a more globalized climate.
From a valuation perspective, P/Es, for example, would be lower than they would in otherwise less stressed times. But not quite to the degree that they were in the 70s.
Investment Strategy Implications
The broad market investment implications of any version of stagflation are rather straightforward – lower valuation levels. Any time quality of earnings is affected, valuation levels must go down.
In a stagflation lite environment, an investor could kiss the current reasonable S&P 500 P/E level of 19 – 20 times (with the 10 year US Treasury at approx. 4%) goodbye. Nor would its historical level of 15 times earnings hold. However, only a stagflation period comparable to the 1970s would produce single digit P/E levels as it did then. Hence the higher P/E probability in a stagflation lite world would be somewhere around 12 times earnings.
If that were the case, then an $82 operating earnings forecast would put the fair value target for the S&P 500 at 984, a full 23% below current levels. Interestingly, 984 brings the S&P 500 down 36% from its high of 1550. In the process, the drop of 554 points from the high achieved in October 2007 would match against the 770 point increase from the low reached in October 2002 (to the high of October 2007) and, therefore, would produce a decline of approximately 75% (from peak to trough). Such a drop would result in a slightly greater than your standard major bull market correction of 2/3s.
Be it stagflation or stagflation lite, it does appear to be a touch premature to make such a call. Nevertheless, the market may be taking some of this thinking into consideration, and so should we. More on this prospect in the coming weeks.
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