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.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.
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.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.
-- Charles Munger, Berkshire Hathaway
Nontraditional HeadwindsJim "El Capitan" Cramer says the bears are "
- 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.
- 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.
- 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).)
- 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.
- The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
- 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.
- 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.
- 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.
- 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.
- 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?