The Top Is Near

The equity market has continued its impressive rally with the S&P rising nearly 32% off of its March 6th low. About half of the S&P 500 companies have reported earnings, with over 65% beating sharply reduced estimates. On average, operating profits have fallen 30% over the prior year. I stated back in my March 29th post (after the S&P had already rebounded 23%) that the rally could last another 10%. We have almost reached that target as the S&P rose an additional 9% in April. I'm revising my prior projection upward by about 5% from current levels, which will result in a short term S&P target of around 920. Let me reiterate my stance; this rally is completely unjustified from a fundamental perspective and the result of technical oversold conditions. Many stocks that I follow are trading at multiples that are unsustainable given the current and future economic climate.

Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.

Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.

The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.



Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html

The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.

This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!