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.

Fair Value

First, I wanted to show two charts.






Now what do they mean? Both derive from Robert Shiller's work. As a quick aside, Yale allows you to view, learn and take tests from his economics course at their website. Now what the first chart shows is the price earnings ratio, that is the price of a stock certificate to the earnings generated for that same certificate. He did this for the entire market, so for my analysis now I just use the S&P500 to continue his analysis. By analyzing his chart it becomes plain that when the P/E is low good returns on average follow. As we all know from a previous post a statistic's professor can still drown in a river that is on average two inches deep. Therefore, Professor Shiller compiled an additional chart that shows further P/E deciles with the maximum return, minimum return, spread between those two points and average return. One can see the clear correlation again, my yellow arrow almost covers all the average return bars, that as P/E's rise the total return falls.

Perfect, so let's go out and invest and be billionaires. Well, we should check to see where we are at currently before we go put a lien on the house to buy S&P Index Futures. Here is the table I generated from S&P's really helpful website.


I took the expected earnings prognosticated from S&P's staff over the next 6 quarters and for the 7th quarter I used a terminal value. The discount rate is the BBB bond yield. I put out the entire equation but as the S&P represents the entire market Beta equals one, thus causing the Risk-free rates to cancel each other in the equation. Finally, a terminal value was established by using the average earnings from March 1988 to present and it is $9.45, then I applied again the same BBB discount rate and subtracted the trend growth rate of GDP at 3%. All these earnings were discounted back and summed to equal a net present value of $141.40, which sounds great. So utilizing Professor Shiller's method I created a table of Earnings and Multiples show here:


So that's great we reached a nadir in March of a sub-five P/E ratio and we are currently at just below 7, so we can expect via Shiller's chart a maximum return off 20%, a minimum of 3% and an average of around 13% over the next ten years. Dialing the home equity underwriter.

WAIT!!!!!
As with everything even though the analysis be true the pillars it stands atop may or may not be the most secure. Now it is true that corporations have done tons for their balance sheets over the past 20 months to secure earnings power. They have cut costs, inventory, staff, R&D, etc. So there is nothing left to cut, they have the bare minimum to continue conducting business. The estimates provided by S&P seem to think that we will just snap back into "normal" corporate earnings immediately. However, what about revenue growth, the top line from which the bottom line springs, doesn't that have to grow for these titans of industry to reach these estimates that analysts have laid out? Only 23 companies show an increase in revenue in this earning season. As I said above there is only so much cost cutting before you need top line growth to propel earnings. Just changing a few items such as GDP growth at 2%, which The Economist quoted in its latest offering, and dropping earnings to 3 and growing from there would put the index at a multiple over 18, which would indicate a max growth rate of 12% an average of 7% and a minimum of -2%. A sobering thought indeed.

As always when investing one should remember "Res tantum valet quantum vendi potest," or a thing is worth only what someone else will pay for it.