Kass: Dry Your Tears With Cold Hard Cash

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 Quote) 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.

Click here for larger image.