Friday, October 9, 2009

Analysis, analysis everywhere but not a drop of think

So I stopped by my favorite, well one of my favorite, spots on the Internet. The S&P500 estimates website and was pleasantly surprised that it now had a spot on revenues. As an aside I am also working on a retail sales spreadsheet but the slog is slow, this is to show how pricing power is declining. So let me put up what S&P has on revenues.

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Below their data set I just wanted to see the data expressed in a level with the beginning of September 2008 as 1. Thus, Revenues at this point are 39.02% below where they were at this time last year.

Then I took a stab at valuing the index based upon expected earnings both operating (excludes write-offs and write-downs) and reported earnings. I used the Baa Corp Bond Yield as the discount rate. For the exit year I used both a P/E of 15 and also a straight line growth of 5% with inflation running at 3%. Here is what I found.

So what is going on in the market looks rational. Based on my crude estimates the index could be overvalued by over 25% or it could be dead on. Bulls versus bears and all that jazz. But this where I draw back to my first chart with revenues. That is, cost cutting can only do so much to hold on to earnings. Are there any other risks to earnings besides the micro factors affecting the companies that collectively make up the index? Then I remembered this chart from Credit Suisse

I first saw this from John Mauldin years ago. Now astute viewers may argue that this is not a big problem. They will reason that it says Option Adjustable Rate and since rates have fallen since these mortgages were underwritten that this will actually be a boon to homeowners. Well, yes and no. It is true that mortgage rates have lowered and when they "reset" it will be to lower rates. However, a portion of these are "recasting." Recast means that the person who took the mortgage took a interest only option, or a "pick-a-pay, " which means that even if the rate is resetting lower because the person will now be responsible for principal as well interest will see their payment jump, sometimes double or triple what they have been paying. This is because the principal has never been actually touched by the monthly mortgage payment or in some cases it has actually grown because of negative amortization. So the proportion of these loans will be key.

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Basically it states that "Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event ... Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize." I'll outsource to my favorite chihuahua "Ren: ...he's DEAD! DEAD YOU EEDIOT! YOU KNOW WHAT DEAD IS? JUST LIKE WE'LL BE IF WE DON'T GET OUT OF 'ERE!"

Now let's have a look at that chart again.

The coming crisis will be about as a big as the subprime crisis. However, because the economy will be a lot weaker than it was when subprime hit this could portend a double dip recession where we take out the March lows before we finally have cleansed the system. I am not suggesting guns and bottled water but gold... it may finally be the time where gold as a store of value takes center stage in your investment portfolio.

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