Monday, 23 February 2009

Everyone's talkin' about Earnings

Recently I've been writing about the dismal earnings outlook for the S&P500 and that based on current and forward earnings the broad market cannot be considered cheap. Two of my favourite financial commentators both wrote about earnings and market valuations this week. Firstly John Hussman of Hussman Funds had this to say: match the worst historical troughs of market valuations, the S&P 500 would have to decline to between 10 and 11 times bottom-channel earnings, and between 5.5 and 6 times top-channel earnings. That would currently translate to somewhere between 500 and 550 on the S&P 500 Index. These levels are emphatically not forecasts – they represent extreme outcomes. Unfortunately, they also cannot be ruled out in the context of a deleveraging cycle plagued by utterly misguided policy responses.

It is essential to understand, however, that at those levels on the S&P 500, stocks would be priced to deliver total returns over the following decade in the likely range of 14-17% annually. The current economic downturn requires us to suspend any optimism that earnings will recover quickly in the coming years, but the iron law of finance – that lower valuations imply higher long-term returns – is likely to endure, as it did even during the Great Depression.

Bottom line don't expect an earnings recovery anytime soon and the risk to the market is clearly to the downside. John Maudlin also had a lengthy and not so optimistic piece on earnings and valuations. Here is an excerpt:

The 20-Year Horizon
The higher the P/E ratio, the lower (in general) the subsequent 20-year average return. Where are we today? As I have made clear in my last two letters, we are well above 20. Today we are over 30, on our way to 45. In a nod to bulls, I agree you should look back over a number of years to average earnings and take out the highs and lows of a cycle. However, even "normalizing" earnings to an average over multiple years, we are still well above the long-term P/E average. Further, earnings as a percentage of GDP went to highs well above what one would expect from growth, which is usually GDP plus inflation. Earnings, as I have documented in earlier letters, revert to the mean. Next week, I will expand on that thought.

And given my thesis that we are in for a deep recession and a multi-year Muddle Through Recovery, it is unlikely that corporate earnings are going to rebound robustly. This would suggest that earnings over the next 20 years could be constrained (to say the least).

Again as I've been stressing for some time, the market has to adjust to the realization that earnings are not going to recover this year or next, the best you can hope for is some stabilization and that analysts stop slashing forecasts, although if you wait for analysts to start revising estimates up you will probably miss the turn.

For more insight on the earnings, valuation and P/E multiple issue, do yourself a favour and read both of the linked articles cited above.