Kass: Bearish Arguments Are Roaring

It is the mark of an instructed mind to rest satisfied with the degree of precision to which the nature of the subject admits and not to seek exactness when only an approximation of the truth is possible.
-- Aristotle

This morning's opening missive will address top-down market valuation, explain why I believe the price-to-earnings multiple expansion beginning six months ago appears to be coming to an end and then go on to recap the forces that make me more bearish on corporate profits vis-a-vis the emerging and more bullish consensus.

Given that the First Call total of S&P operating earnings for the first half of this year was about $30.50 a share and is estimated at $15 a share for the third quarter ending Sept. 30, 2009, it is safe to say that 2009 S&P operating profits will approximate $62 a share. First Call consensus S&P earnings forecasts for 2010 now run around $72 to $74 a share, for a gain of almost 18% year over year.

Many strategists (both bullish and bearish) assume that a fair value P/E multiple -- based on interest rates and inflation -- rests at about 15.5 times. Averaging the 2009 and 2010 S&P consensus forecasts produces a melded $67.50 S&P EPS, a year-end target of 1045 and a mid-2010 S&P target of 1130 on an EPS of $73 a share -- against the current S&P level of 1043.

Bearish strategists such as David Rosenberg (this weekend's Barron's interview) believe the current S&P level is discounting a 40% increase in 2010 earnings over 2009, but the consensus believes (above) that about 10% growth is being discounted.

Bearish strategists (again) like Rosie expect real GDP growth of about 1% to 2% next year, but the consensus now anticipates 3% to 3.5% growth in 2010.

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.

There is always the need for rigor in the analysis of the economy and profits. We know history rhymes and that we must rely on past relationships, even after adjusting for the new reality/reset to frame our views. But, to some degree, the same set of economic series and charts (used by strategists) that failed to appreciate the historically unique and shaky foundation of credit-driven economic growth in 2002-06 might be underestimating the economic consequences of the Great Unwind of Credit, the ramifications of the massive policy decisions that were necessary to counteract the building recessionary conditions in 2008 and the unfolding of numerous nontraditional headwinds.

Nontraditional Headwinds

Jim "El Capitan" Cramer says the bears are " ignoring the good news at their own peril". I would argue that the bulls are ignoring the emergence of a number of secular headwinds. Here are 10 of them:
  1. Deep cost cuts have been mainstay of corporations over the last few years. Cost cuts are a corporate lifeline (like fiscal stimulus), but both have a defined and limited life. Ultimately, top-line growth is needed.
  2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the labor force. The consumer remains the most significant contributor to domestic growth. Unemployment should remain high, exacerbated by many retiring later in life because their nest eggs have been reduced.
  3. The consumer entered the current downcycle exposed and levered to the hilt, and net worth (and confidence) has been damaged and will need to be repaired through time and by higher savings and lower consumption. (The consumer is hurting. Last week I met with a midsized bank's lending team. The bank is seeing a big mix change toward rising use of their debit cards (where money is in the bank) at the expense of credit cards (where money is then owed).)
  4. The credit aftershock will continue to haunt the economy. The unregulated shadow banking industry is dead, as is the securitization market. All signs indicate that banks will likely remain reluctant to lend to individuals and small businesses. Just try to get a jumbo mortgage today.
  5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
  6. While the housing market has stabilized, its recovery will be probably remain muted. More important, there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
  7. Commercial real estate has only begun to enter a cyclical downturn. It might not be as deep as many expect, but it won't provide much of a contribution to growth.
  8. While the public-works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye -- most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
  9. Municipalities have historically provided economic stability during times of economic weakness -- no more. They are broadly in disrepair. State sales taxes are being raised all over the country, and so are sin taxes (to shore up municipal finances) on cigarettes, booze and maybe even sugar products.
  10. The most important nontraditional headwind is the inevitability of higher marginal tax rates. How will higher individual tax rates affect an already deflated consumer? How will corporations react to higher tax rates? Will rising taxes be P/E multiple benders?

How Now, Dow Jones?

The liquidity that grew out of the massive government stimulation and the growth in the monetary base is reaching the equity market and our economy. It has been greeted by cheers and almost unnoticeable, brief and shallow pullbacks in stocks, producing a degree of price momentum that is almost reminiscent of the "good old days" in 1999/early 2000. Market participants appear now to have embraced the notion that we are in an economic "sweet spot" and that a below-average but self-sustaining domestic recovery is being endorsed.

With the perspective of the large market rise and dramatic change in sentiment (from dire to positive), there is now little room for disappointment.

A Secular Reduction in Credit Creation and Financial Inventiveness Lies Ahead

Coming out of the last several recessions, aggregate economic activity moved quickly back to peak levels -- but, consistent with the accepted shallow-recovery thesis, it won't be as quick to recover this time. David Rosenberg expresses in Barron's that the secular rise in credit expansion of the past several decades could be a thing of the past in the years ahead, producing a truly different experience this time. While we have to try, it's hard for me to be confident in the certainty and precision of a baseline view, especially within the context of the long and uncertain tail of all the nontraditional headwinds. With financial inventiveness being put on the back burner, unbridled, unregulated and (sometimes) unsavory debt creation will no longer catalyze growth in a world where banks are reluctant to lend, the securitization markets are broken and the shadow banking system is nearly extinct.

While it's fortunate that our financial institutions have reduced the chance of systemic risk by decreasing their balance sheet debt, the U.S. government has taken the banking industry's place. And with that come challenges anew over the next decade.

Like Berkshire Hathaway's Munger argued, those challenges and the bills associated with policy are being ignored -- or investors believe they can get out before they come due.

The credit and stock markets have been buoyed and dominated by the better-than-expected earnings cycle. The replenishment of historically low inventories, the effects of recent and extraordinary fiscal/monetary stimulation, a recovery in residential housing activity and the productivity gains from draconian corporate cost-cutting are favored in influence by Jim Cramer (and others) and have clearly trumped the potentially negative consequences and those due bills of policy.

But stimulation is by definition bringing sales forward, and Policy (with a capital "P"!) has its consequences. Some programs (like "Cash for Clunkers") have the potential for borrowing from 2010-11. Others, like mortgage credits and even monetary policy, have a finite life to them. They end and the artificiality of the stimulative initiatives is lost -- and the economy becomes "real" demand-dependent. Given the past shock, it's hard to see a solid view of that demand.

Consumer Remains the Achilles' Heel

Then there is the consumer, who remains particularly exposed in the period ahead. Private wages and salaries fell by a record 5.2% annualized rate in July. While some improvement from depressed levels can be expected, the labor market remains weak and jobless claims are still elevated. The possibility exists that the consumer will retreat from the decades-long aspirational spirit and turn back toward the legacy of the post-Depression mentality of maintaining the status quo. With this reset could come disappointing personal consumption expenditures and a higher level of savings that will likely match the post-World War II average savings rate of 7.5% and could even begin trending back toward the direction of double-digit savings rates that existed in the recession of the early 1980s.

Summary

In summary, the market has discounted favorable expectations (certainly against forecasts four months ago!) and seems more "certain" of a self-sustaining recovery cycle outcome. Reflecting the gravity and weight of so many inhibiting factors, I see a much broader range of possible outcomes and less certainty than some of the newly printed bullish market participants.

The credit expansion of the last several decades has reversed, it will take time to reverse the damage to net worth and confidence, the consumer remains in a fragile state, corporations will make do with more productive but fewer personnel (job growth could continue to disappoint), there are no apparent drivers to replace the role of housing (2002-06) and numerous nontraditional headwinds (most importantly higher marginal tax rates) will have an uncertain impact on aggregate growth.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Long/Short LP.

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