Wednesday, October 22, 2008

It's Still the Economy, Stupid

Wow, that was a pretty ugly day in the markets. I listened to the chatter among the technicians all day and they were worried about the Dow's inability to hold above 8,700. There were very prominent bears (people that are negative on stocks) that shifted to being bullish (positive on stocks) over the last couple of weeks based on the charts. However, the charts are starting to point toward a double dip and many of the trend chasers got cold feet today. Although, the markets have traded lower on an intraday basis, this is the lowest we've closed and that will get a lot of attention.

As I said for some time, earnings for the third quarter have been ugly and the outlook for the fourth quarter is worse. There is a pretty simple formula that says if you take the price of the S&P 500 (roughly 900) and divide it by the earnings of those stocks, you get a p/e multiple for the market. In great times, this P/E number can be as high as 15 if things are booming, if you have a great deal of confidence in earnings and earnings are growing. Six weeks ago, the S&P 500 companies were estimated to earn $95 next year. Today I heard a revised estimate for the S&P 500 earnings for next year of $60!!

How could that be? Well, it seems like the US firms are being hit by a triple whammy of a dramatically weaker US economy, a weaker Global economy and a stronger US dollar. The US dollar strength is a bit of an aberration, but weak economies are not going to improve despite all of the bailouts.

If the $60 earnings number is correct, then despite the collapse of stock prices this year the market is still trading at 15 times 2009 earnings (implying things are great, you have great confidence in the numbers and earnings are growing). Unfortunately, when you have limited confidence in earnings, the economy is entering a recession and earnings are shrinking, that earnings multiplier can fall as low 7-10. This means in a worst case scenario the value of the S&P could be as low as 420 to 600 (down another 30-50% from here). I only assign a 25% probability to this scenario but that is up from about a 5% chance a month ago.

I remain convinced that this is not going to be a little blip of a recession, this is more likely to feel like 1973 or 1981, which were much more painful experiences.
Other Interesting Stories on the wires....

Calpers Looks to Shore Up their Fund

The California Public Employees' Retirement System, known as Calpers, said its assets have declined by more than 20%, or at least $48 billion, from the end of June through Oct. 10. (How in the world can a pension lose 20% of their assets in 3 Months?)

Unless returns improve, Calpers is poised to impose an estimated increase in employer contributions of 2% to 4% of payroll starting in July 2010 for about two-thirds of its state-employer members, and in July 2011 for the remaining third. Any decision will be made after Calpers knows its returns for the fiscal year. So to make up for their investing mistakes, Calpers is going to increase employer contributions. Since the "employers" are public entities like city employees, teachers, etc., guess who gets to foot that bill? Taxpayers in California.

**************************************************************************** profit soars but outlook and stock down


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