Analyzing Bottoms

Many investors are pointing to "cheap" valuations as a reason for buying equities. Based on the current "bottoms-up" consensus, the SP 500 is trading at 10x, cheap by many measurements. Well, cheap things usually break easy and don't last long and from this viewpoint I would agree that this market is "cheap."

Looking at the projected "bottoms-up" earnings for the SP 500 we find the following: 2011 of $98 and 2012 of $112. Put differently, the earnings growth rate analysts are expecting in 2011 is 17% and in 2012 is 14%. Seems aggressive when U.S. GDP growth is slowing. Analysts argue that a large portion of the revenue from companies within the SP 500 comes from outside the U.S.. Fair enough, but Europe isn't exactly exploding with growth. Exploding possibly, but not in a good way. Developing markets are increasingly pinched between high inflation and slowing growth. And, let's face it, if both Europe and the U.S. enter a deflationary period the chances of developing countries side-stepping a recession are remote.

So what is a realistic earnings assumption? Going back to WWII, companies in the SP 500 have seen earnings pull back on average about 15% during a recession. Assuming earnings come in around $95 for 2011, this would imply 2012 earnings of about $82 and a current P/E of 14x. Not an unreasonable valuation if you expect the economy to bounce back quickly. The 2008-2009 recession witnessed a 50% pullback in earnings largely due to the decimation of the financial sector, implying earnings of around $50 in 2012 and a P/E of 23x. Given that some investors are claiming the potential problems in Europe are worse than the collapse of Lehman due to the sovereign debt risk, this outlook cannot be pushed aside. Suddenly the market does not look so cheap.

The final point I'd like to make is that the P/E tends to contract when prices are less stable. Both high inflation and deflation tend to result in lower P/E multiples. An inflation rate, as measured by CPI, above 5% or below 0% is highly correlated with a P/E below 12x. This suggests if we enter a recession and deflation takes hold the P/E for the market likely contracts on top of lower earnings.

Using an average recession as the baseline for my investment decisions, I am going to assume that a realistic earnings forecast for 2012 is $82. I will note that this puts me at the low end of published forecasts and well below the mean of $112. I also believe that deflationary pressures are quite strong in the economy due to falling house prices, fiscal austerity, weakening monetary stimulus, high unemployment, anticipated falling prices in commodities, high consumer debt levels, and over-supply of retailers. Due to these potential deflationary pressures, I'm going to assume the CPI turns negative at some point in 2012. Putting a 10x multiple of this estimate I arrive at a SP 500 price of $820. Of course if this scenario plays out, or proves more like 2008-2009, the fear in the market is likely high, potentially causing the SP 500 to dip well below this mark.

Based on this analysis I plan to keep my 60+% position in 30-year treasuries. If the yield falls below 3% then I will need to re-evaluate the position. I also am maintaining a significant cash position of around 20%. My 20% position in equities is largely focused in higher dividend yielding domestic energy, healthcare, utilities, and consumer staple companies.