Going Out on a Limb

Although decelerating, momentum pushed up the S&P500 yet another week–this time by 1.5%. 

Economic fundamentals did not improve, as usual.  Housing starts and permits–whose bounce in March provided some of the reasoning behind the recent green shoots propaganda–resumed their downward trek.  Producer prices and consumer prices fell; in fact, the CPI’s -0.4% yoy decline was the first annual decline since 1955, certainly not supporting a rebound in economic activity which would typically push up CPI on a yoy basis.

Also, retail sales dropped in March, which was totally unexpected:  consensus estimates called for an increase.  Industrial production fell by more than projected and capacity utilization fell to the lowest level on record.  Initial claims stayed elevated (in the 600K range) and continuous claims rose to yet another all time record: 6.02 million.

Technically, the S&P is now even more oversold than last week, and setting itself up for a short trading opportunity.

The Standard and Poor’s top-down analysts regularly update their forecasts for S&P500 as-reported earnings.  Over the last two years, the accuracy of their forecasts has been notably higher than the consensus of the bottom-up analysts who typically have a long bias because their firms often sell the products (stocks) they analyze.

The Standard and Poor’s most recent projections for 2009 and 2010 as-reported earnings for the S&P500 are $29 and $35, respectively.  So at the current price of the S&P (870) and using the higher of the two projections for earnings ($35), the P/E ratio is 25.

Now 25 doesn’t seem too high when compared to the trough P/E’s from 2002 and 2003 (also about 25), but we’re not dealing with your typical recession today.  Instead, we’re living through the mother of all asset and credit bubbles–and we’re not anywhere close to the end of the storm.

Arguably, therefore, we must look to other more secular (not merely cyclical) bear market lows to put the current P/E ratio into context.

In the 1970’s, the 1950’s, the 1940’s and the 1930’s, the P/E of the S&P bottomed out at well below 10. 

So today, if we apply a P/E ratio of 10 (and not lower) to the $35 earnings projected for the S&P in 2010 (and not the lower earnings projected for 2009), then it becomes perfectly plausible that the current S&P valuation might risk leaving some investors feeling like they’ve gone out on a limb.

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