RealMoney Silver - Kass: Dry Your Tears With Cold Hard Cash

Kass: Dry Your Tears With Cold Hard Cash
By Doug Kass
RealMoney Silver Contributor
1/3/2008 12:32 PM EST

This blog post originally appeared on RealMoney Silver on Jan. 3 at 8:01 a.m. EST.

Reported S&P 500 profits will likely be slightly negative this year, thanks to some large charges at General Motors (GM) and the multiple blunders at a number of misguided and gluttonous financial institutions.

The modest 2007 rise in the S&P 500 of under 4% has resulted in a P/E multiple of approximately 18 times trailing 12-month earnings as of Dec. 31, 2007. If one takes out the still-low P/E multiple associated with energy stocks of about 12 times, the non-oil S&P trailing 12-month multiple rises to 19 times, above its historic average.

Lost in the analysis of 2007's equity performance has been the P/E multiple expansion in the equity market, after one excludes financial stocks. Indeed, without the financials, the S&P would have had a low double-digit return.

While the numbers are not yet out, I suspect that, excluding energy and financial stocks, the S&P 500 is now trading well over 20 times my forward 2008 S&P profit estimates. (Remember, I am looking for a 10% decline in earnings.)

Stocks rarely rise from over an 18 times P/E multiple unless profit margins rise or bond yields drop.

Because profit margins have already begun to fade under the pressure of higher costs and tepid top-line growth, and with the financial retrenchment in the banking system only recently under way as asset quality deteriorates even further (as seen in the chart below), it's hard to see overall profitability improve in 2008-09.

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With the exception of the most dogmatic (namely, being of a Ben Stein-kind), many observers are downgrading their economic expectations. Ironically, even those more adamant proponents of Goldilocks -- including Sir Larry Kudlow and Dr. Arthur Laffer -- are calling for 50- to 100-basis-point Fed interest rate cuts. Go figure.

So, the burden for 2008 P/E expansion seems to rest uneasily on the shoulder of lower interest rates.

To be sure, we should not ignore the market's multiple to government and corporate bond rates, as the earnings yield to bond yield spread is at a level consistent with a market bottom (not a market top). Nevertheless, a good amount of the recent yield decline represents a flight to quality, which could be fleeting, and the growing recognition that economies are faltering.

As to the future direction of interest rates, my view is that, even despite the U.S. economic weakness, central bank diversification efforts coupled with persistently high inflation in energy products, wages and commodities will cause the yield on the 10-year U.S. note to rise in 2008. Even if I am wrong, however, and interest rates drop, putting the onus of higher P/E multiples on lower interest rates seems to be a stretch given the eroding sequential trend and likely lower level of 2008 profits.

The bulls argue that it's not different this time. After all, the conditions that typically presage a recession are not present -- for instance, inventories and capital spending are not high relative to sales, the Fed is loosening, interest rates are declining (not rising), and corporate default rates are quiescent.

Those observers would also emphasize that, despite a weak U.S. economy, non-U.S. growth will be incrementally positive. So, they calculate that, with 2008 S&P earnings rising by 2% to 3% just from export strength, a nominal U.S. GDP growth rate of 4% to 5% will add another 4% to 4.5%, producing aggregate profit growth of 6% to 8% this year (though well below the 13% bottom-up earnings estimates by analysts).

Bears, such as myself, argue that it is different this time. We argue that tepid top-line growth coupled with margin erosion is a toxic combination that will produce reverse operating leverage.

Moreover, the egregious expansion in debt and credit over the last decade and its role in creating the mortgage delinquency mess significantly added to domestic growth in the past and will begin subtracting from it in the future, particularly with corporate profit margins at a 52-year high, as job losses and a mean regression in credit experience are reasonable expectations in the fullness of time.

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My ursine crowd would also emphasize that the conspicuous, forward and leading indicators of weakening growth, such as yesterday's horrible ISM manufacturing survey, coupled with a large jump in the prices-paid component, surging gold prices and a $100 print in crude signal blahflation -- that is, a period of uneven and inconsistent growth mixed in with stubbornly high inflation.

As well, we bears would add that investors shouldn't believe in the decoupling theory, as investors should recognize the important role that the U.S. consumer plays on worldwide growth as well as observing the emerging drain due to developing weakness in the Western European and Japanese economies.

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From my perch, investors should consider the idea that it might be high time to face the market's melancholy music -- and start raising some cash.