It's only worth what someone else will pay for it

One of my pet peeves has been all the talking heads... including the President this morning... trying to tell me (and you) that the valuation of the stock market is amazingly low and needs to be bought at these levels because it's 50% lower than it was last year.

Let's have a little lesson on valuation:

* The long-term Price/Earnings ratio for the stock market is 10x.
* The trough market valuation in the 1980-82 recession (as well as other recessions) was 6.8x earnings.
* The earnings estimates for the S&P 500 have dropped almost $2 over the past week.
* The current forward P/E ratio for the S&P 500 is 11.3x

What's that all that mean?

* Assuming earnings do not drop further, the market is still currently valued at 13% above median long-term valuations.
* Assuming earnings do not drop further, the market is 40% above trough valuations. That means we could see the S&P get close to 400 and the Dow get close to 4000.
* My assumptions include this recession/whatever-you-want-to-call-this-pain not being any worse than the 1980-82 downturn and EARNINGS NOT DROPPING ANY FURTHER.

You might have picked up on the fact that the assumption that earnings will not drop any further is a big stretch for me. And if earnings do drop... then what? Well, if earnings drop by 25% from here? Hmmmm. That means that the forward P/E would currently be 15x... meaning it would be 55% above the trough valuation.

Sleep well tonight.

That's why we invited you...

When I was a little girl, one of the songs my mother used to sing to me when I was being cranky went something like:

"Every party has a pooper, that's why we invited you, Party Pooper."

I'm finding that this is a role I'm taking on more and more lately. It's not that I enjoy being a wet blanket, really. I'm actually quite fun to be around, as long as we're not talking about the economy. So, what's set me off this time?

The International Council of Shopping Centers has recently released a report calling for 73,000 stores to close their doors during the first half of 2009. The first HALF. Six months. Not shocking to me or you, if you've been reading this blog.

In light of that, though, could someone please explain to me (using small words) how some of the portfolio managers on television can possibly be excited about the market going forward? 73,000 store closings is a little bit more than a pebble dropping in the ocean. If you truly think about everything and everyone that goes into running a single mom & pop type shop, you will quickly realize that we're talking about a lot of unemployed people and lost GDP.

There are roughly 600 good malls in America. Obviously not all of the possible stores closing are in malls, but humor me for a minute. Let's say the average mall has 200 stores, which is probably high. So in my example there are 120,000 mall stores in my world... and 73,000 are turning up their toes and dying. Hmmm. That's not ugly. ::cough::

I'm all about the Darwinian evolution of retail. I have absolutely no problem with bad retailers failing. The culling of the herd is a good thing. What I have a problem with is folks not realizing that those failings will have an impact on the economy. The thought that one guy floated today (had I been more awake I would have noted his name, but it was early out here and I was suffering from a caffeine deficit) was that it was already priced into the market because these were the lowest valuations he'd seen in his thirty year career.

Here I go again, but just because it's the lowest valuations that you've seen in your career doesn't mean that it's as low as they go. A sense of history is important. And a realization that the past 10 years (or more) have been extraordinary times and valuations in the market is also rather useful. With all that the consumer is still facing, I just don't understand how anyone can believe that we're in for any sort of a rebound to recently normal valuation levels. While the US market has traded at roughly 14x earnings in recent history, the longer term valuation level is closer to 10x. And when the pendulum swings, it always goes past center in the other direction.

I understand the theory that you buy stocks before the end of the recession. Retail in particular starts to rally 6 months before the end of the recession. But given the landscape, I just don't see how we are out of this recession in 2009, which means that keeping powder dry is still in order for private clients. We're going to play this rally for as long as it holds, but I don't expect that to be longer than March. Trades to go to majorly defensive positions are going to be teed up and ready to go.

Cheap is as cheap does

I'm sitting here scratching my head, trying to figure out what it was that caused today's incredible rally toward the end of the day. Maybe there was a hedge fund convention that started at 1pm eastern, mandatory attendance gentlemen, and that let up the selling pressure for a few hours? Or maybe some Mars moved into the orbit of Venus causing an updraft in the positive energy flow amongst the planets and intra-day traders. I've read a couple of articles that attempt to explain it as the reaction to ultra cheap stock valuations, but that explanation makes as much sense to me as the first two ideas I floated.

For stocks to be cheap, there has to be some benchmark to measure them against, whether it is peers, expected earnings, or history. The problem is that I don't think that we really have a clue what earnings are going to be for a majority of companies, the historical basis we're considering is too short (putting them versus the last 5 or 10 years is, dare I say it, just plain stupid - we're in an economic situation that goes back at least 30 years, if not 80 years), and when you put companies up against their peers the only relatively expensive companies are the companies that are actually doing okay in this economic malaise (you know, the only companies that I wouldn't mind owning at this point.)

Case in point: in the retail landscape, it's hard to find a company doing better than Wal-Mart, and they're relatively expensive too. They reported earnings this morning that were a penny better than expected (a huge accomplishment for a company of their size!) Now the headline you might have seen splashed about was that they took guidance down for next quarter, but that was because of a swing in foreign exchange, not because of operational issues. If you take the $0.06 hit that they are expecting from foreign exchange out of the equation, they are actually taking guidance UP for Q4. That is the kind of company I want to own.

Let's contrast that with the reports this afternoon from Kohl's and Nordstrom. They're both good operators: good management, good systems. Crappy sales. To quote my favorite former CIO, you might call the numbers they put up 'dismal and deleterious.'

On the surface they theoretically both beat expectations, but I'd hope at this point that you're looking below the surface. Kohl's actually beat expectations by a penny, but took Q4 earnings guidance down by 1/3. Customers just aren't buying. So is it cheap at 10x earnings? Maybe, if you truly believe that they'll grow earnings at 14% over the next 5 years... but do you REALLY believe that? I didn't think so.

Nordstrom beat recently lowered expectations by $0.02, but that result included a help of $0.03 from non-recurring items that they hadn't included in previous guidance. Or, put another way, they reported real numbers that were a little worse than they guided to a week ago. Oh, and then they put some icing on the cake... they lowered earnings by HALF for Q4. HALF. Hello, Seattle? We have a problem. This is the third time they've taken guidance down this year. And to have earnings looking like something closer to $0.35 for Q4 than $0.70, that's just abysmal. So it's trading at 5.4x times next year's earnings, doesn't that make it a buy? Sure. Go ahead. But use your money, not mine.