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Kass: Bearish Arguments Are Roaring

The market's P/E multiple is up by 5.5 points, or more than 40%, since equities bottomed in early March. So, even for the bullish strategists, the phase in which expanding price-to-earnings multiples contribute to the market's advance is largely over and future stock market gains will be dependent upon the achievability of a healthy growth in S&P operating earnings toward the consensus.

My Take

In poker terms, the Treasury and Fed have gone "all in." Economic medicine that was previously meted out by the cupful (pumping dollars into the economy) has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation.
-- Charles Munger, Berkshire Hathaway

Stated simply, my argument is that the earnings expectations for 2010 -- the level and growth rate -- will disappoint, and the expectation of disappointment has brought the market into overvalued ground. (As an aside, if the P/E multiple expansion phase of the market is indeed closing, it suggests that market leadership will likely shift from low quality to outperformance of self-financing, large-market-share owners of higher quality).

Let's assume we can all agree that the full extent of the P/E expansion phase is about over, and that further market gains will rely on the realization of the optimists' baseline expectation (which now seems to be generally accepted by the consensus of most strategists) of relatively smooth and solid earnings growth for 2009-2011. Even on the consensus expectations, the market appears to be fairly valued now and somewhat undervalued (by about 9%) on a 12-month forward earnings basis.

While I accept that the baseline consensus expectation of S&P 2010 EPS of $73 a share is a possible and logical outcome, a double-dip would not be illogical considering the economic, credit and equity markets' "heart attack." I would argue that there exists a wider range of economic and profit outcomes than is customary during a "recovery" phase, and that the certainty associated with today's consensus of a positive outcome could be tested.
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