To me this swine flu outbreak looks a lot like avian bird flu; fairly contained and overhyped. Of course anything is possible, but as Wall Street frets about swine flu (Dow futures are down 150 this morning), investors should be on the lookout for investment opportunities. Worries over bird flu led to numerous bargains, especially in the poultry industry. We’ll have to see what stocks, if any, are adversely affected by swine flu worries. Chances are they will excellent investment opportunities just as were available when SARS and bird flu were the worries of the day.
Are you surprised that the market is acting as well as it has lately, especially with earnings season having begun? Still waiting for that overbought correction after six weeks of gains in stocks? Me too. Why the relative strength? Well, according to Bespoke Investment Group first quarter earnings are coming in well above estimates so far (20% reporting):
“A fifth of the companies in the S&P 500 have reported earnings for the first quarter, and so far earnings are down 16.6% versus the first quarter of 2008. While down, this is much better than the -37.3% expected at the start of earnings season. When comparing actual earnings versus estimates, Consumer Discretionary, Financials, and Energy are leading the way. On the downside, the Industrial sector is the only one where actual earnings have come in weaker than expected. Earnings season still has a long way to go, but the fact that growth has come in better than expected thus far has been one factor driving the market higher.”
Some people are making the case that the stock market can rally meaningfully even without the financial sector recovering. I disagree simply because earnings are being negatively impacted so severely by loan losses and mark to market writedowns at the large financial institutions that investors won’t get a clear picture of what a reasonable expectation for S&P 500 earnings are until financial sector earnings at least stabilize, if not climb back toward breakeven.
Jeremy Siegel, well known Wharton finance professor and author of “Stocks for the Long Run” (an excellent book) had an opinion-editorial piece in the Wall Street Journal recently that was titled “The S&P 500 Gets Its Earnings Wrong” (subscription only — get 2 free weeks here if you are not a WSJ online subscriber) that made some interesting points about the currently depressed level of earnings for the S&P 500.
Dr. Siegel explains that while the S&P 500 is market value weighted (larger companies are weighted more heavily in the index than the smaller ones), Standard and Poor’s does not use the same methodology when calculated the index’s earnings. Instead, a dollar of profit from the smallest stock is treated the same as a dollar earned by the largest. As a result, the losses being accumulated by a small portion of the index are negating the profits being generated by the majority, which is making the S&P 500’s earnings look overly depressed.
Consider the data below, taken from Siegel’s column:
Siegel is suggesting that the absolutely abysmal financial performance of the market’s worst stocks last year (mostly from financial services firms, of course) is giving the appearance that corporate profits have absolutely fallen off a cliff in every area during this recession.Â He is quick to point out that 84% of the largest 500 public companies in the U.S. (420 out of 500) are actually doing quite well. That fact is going unnoticed because $1 of earnings from the smallest stock in the S&P is treated the same as $1 of earnings from the largest component, even though an investor in the S&P 500 owns 1,300 times more of the largest one than the smallest.
I’m not sure if Siegel is suggesting that they should actaully go ahead and change the way they calculate S&P 500 earnings (and if so, I’m not sure I would even agree with him), but I do think this data is very helpful in seeing just how much the financial sector is masking corporate profits from other sectors.
My personal estimate right now for S&P 500 fair value is around 1,050 (14 to 15 times normalized earnings of between $70 and $80). I came up with those estimates before reading Siegel’s article, but the data he provided give me comfort in the estimate. After all, if you assume the bottom 80 companies get back to breakeven and the other 420 companies maintain their 2008 profitability (both are conservative assumptions when the recession ends in my view), we see that S&P 500 earnings would range from $67 (if you use GAAP earnings) to $81 (if you use operating profits)
As you can see, any relief for the financial sector with respect to mark-to-market accounting principles could temper the writedowns going forward. Even getting the financial sector to breakeven by 2010 would reduce the negative earnings impact from the bottom 6% of the S&P 500, clearing the way for earnings to rebound pretty quickly from the $40-$50 level analysts are projecting for 2009.
Barry Ritholtz, market veteran and blogger over at The Big Picture postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.
Personally, I expect more from Barry given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don’t know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index’s components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.
Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a business person interested in buying your store. What would your reaction be if this person took your store’s profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits. Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!
The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.
The second issue with Barry’s analysis is the use of “as-reported” GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock’s value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don’t really play a role in fair value estimations.
The interesting thing is that you don’t have to take my word for it on this topic if you don’t want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.
Market strategists call it a “bottoming process” or “building a base.” The chart below shows the S&P 500 over the last three months and you can see what they are talking about. Earnings estimates keep dropping, job cuts keep pushing up the unemployment rate, GDP continues to contract, but the S&P has been going sideways in a range between 750 and 950, even in the face of three months of bad news. No rally has been sustainable, but the market isn’t getting significantly worse.
Some think this trend is a good thing, others would like to see the market rising in the face of bad news, but it is too early for the latter. There is no doubt that it is a positive sign that the market seems to have come to grips with the reality that job losses will continue, corporate profits in 2009 will stink, and the unemployment rate is headed well over 8% this year (from 7.2% currently). Since the market discounts future events ahead of time, current market prices appear to have priced in the consensus economic forecasts for 2009. Of course, we don’t know if those assumptions will prove accurate or not. Only time will tell on that front.
For those looking for a large market advance, we likely won’t get one that is sustainable until the economy shows signs of stabilizing. Just like stocks hit bottom before the economic statistics got worse, stocks will begin to rise before the economy begins to grow again, but we are likely facing months of stagnation before that happens. As a result, the last three months of sideways market action makes sense. Things might not get too much worse than most are expecting, but a recovery is going to take time.
Aluminum giant Alcoa (AA) kicks off fourth quarter earnings season after the closing bell today and there is little doubt that they will be the first in a series of profit reports over the next few weeks that will be absolutely brutal. Fortunately, most investors already know that, so the market’s reaction is unlikely to mirror the dramatic sell-off we saw in October and November. The fourth quarter could prove to be the weakest quarter of the entire recession in terms of GDP growth (a 5 or 6 percent decline is both possible and probable), which would imply that corporate profits have no chance of exceeding expectations this quarter.
The key, however, is not what the numbers are but rather how the market reacts to them. With sentiment so negative on the earnings front, there will be instances where stocks actually do not drop, or even rise slightly after poor profit reports are announced. Since the stock market is forward looking, a company reporting a lousy number, if no worse than expected, will actually bring smiles to investors’ eyes because it alleviates the concern that things could be even worse than many believe they are.
How the market reacts during this earnings season will be very telling for the near-term dynamics of Wall Street. If numbers come in weak as expected, but not a lot worse than the already low expectations, technical analysts will be quick to point that out as a positive sign. This would be a key signal that the market has reached a short term bottom. Such action would tell me that the market is truly looking ahead to possible economic stimulus and other actions that could help make the fourth quarter the worst quarterly GDP reading we ultimately see.
Conversely, a poor market reaction to these profit reports could mean a retest of the November lows. The market has done pretty well in recent weeks as it looks ahead to an Obama administration, but its patience will certainly be tested over the next couple of weeks. Personally, I think we will see a modestly negative reaction over the short-term, only because we have already seen a decent level of bargain hunting prior to earnings season.
Full Disclosure: No position in Alcoa at the time of writing, but positions may change at any time
I have heard it twice on CNBC already this morning, and the market has not even opened yet. For some reason people are claiming that since the market is up more than 20% from its lows that we have entered a new bull market. This idea that any rise of at least 20% constitutes a bull market is just plain silly. If a stock falls from $10 to $1 and rebounds to $1.20 it’s a new bull market? Oh, please! Sorry folks, but there is no bull market in stocks, or oil, or anything else that has been crushed in recent months but has recouped a small portion of the losses.
To get an idea of how bad the high yield debt market is right now, one need only look at what price El Paso (EP) had to pay this week to issue $500 million worth of senior notes. El Paso is a solid company and should not have trouble selling debt. Their hybrid business model; energy pipelines coupled with exploration and production, makes their cash flow more predictable than more narrowly focused energy companies.
Still, El Paso is paying 12% interest and even with such a coupon rate, could not sell the notes at par. Instead they discounted them to entice buyers, who will earn 15.25% by holding to maturity. Why did EP sell such expensive debt? They have more than $13 billion of debt, with more than $1 billion coming due in 2009, and wanted to refinance until 2013.
Hopefully deals like this will continue. While they do not represent bargains for issuing companies, an increase in corporate debt offerings will be crucial for getting improvement in the corporate debt market. Once it becomes more clear that companies can issue new debt (even at high prices), the pressure on common stock prices of highly leveraged firms will abate, removing one of the largest elements of fear in today’s equity market.
Full Disclosure: Peridot was long shares of El Paso preferred stock at the time of writing, but positions may change at any time
Simply judging from the stock market’s performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.
As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.
The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980’s. It is a gift for long term investors.
Today is a perfect example of why I do not recommend that long term investors, regardless of how afraid they are right now, sell their stocks into oversold equity markets to minimize short term pain. When sentiment is so negative, the mere nomination of a new Treasury Secretary can result in a 500 point Dow rally within hours.
All of this announcement did was lift some uncertainty from the market, but traders hate uncertainty. Does it matter that Geithner was one of the two or three people most talked about for this job? Not at all. All that matters is that now we know who it will be.
Now, does this mean we won’t be down 500 points on Monday? Of course not. The point is, when markets are down so much and have priced in so much negative information, it does not take much to get a massive rally. Imagine what would happen if economic data begins to improve sometime next year?
Unless you are psychic it is very difficult to get out of the market and get back in time to catch most of the rebound. With electronic trading and instant dissemination of information these days, the market can move a couple thousand points in a matter of days (which nowadays is a 20-30% move). The odds are against you being able to get back in fast enough, which is why I don’t even try.