Expectations for Q2 2009 earnings plummeted steadily over the past year to a point where they were sufficiently low that they were fairly easily beat –albeit with large doses of government stimuli, gimmicks, accounting rule changes, and overt deception.  The same game is going to be played for Q3.

Their series of estimates tells us a few interesting things. First, analysts are notoriously over-optimistic. Look at the September 2008 estimate. You may recall that September 2008 was the Lehman meltdown and corresponding global financial system meltdown. Everyone was worried about the solvency of their bank. Merrill Lynch was sold to Bank of America in a shotgun wedding (await the lawsuits). During this time analysts prognosticated $26.29 in earnings for Q3 2009 (12 months into the future). Now that we are in Q3 2009, estimates have been cut by almost half. To which, you might say – well done analysts!

This also tells us we should place little value on consensus analyst estimates for earnings any more than about 3 months in advance (or not at all).

This exercise is meant to give us perspective. Analysts are (now) prognosticating $54 of earnings (from operations) for calendar 2009 (about $45 of as-reported / a.k.a. real earnings). Given that we are 2/3s of the way through the year, I am inclined to put some faith in the $54 2009 earnings estimate (from operations) – but not much faith in the 2010 estimate.

They are forecasting $73 of 2010 earnings from operations. Folks, there is no chance we’ll see $73 in 2010. The best we’ll see is $60 (and about $50 in real earnings / as-reported).  In order to see $73 in earnings we would need to experience the single largest spike in profitability in the history of the USA. Given what we know about our current economy, how likely is that? Yet this is what is priced-in to the market at this time (at these levels: S&P500 at 1030).

So where does all this leave us in terms of where the S&P500 is fairly valued and what is the range for it in the coming 6 months?  And how are we to invest (in US equity)?

Fair Value:                                                              

  • 750 (based on as-reported earnings — the earnings figure we used to use, up until a decade ago when CFOs began playing games in a big way)
  • 900 based on earnings from operations. (earnings before b.s.) (widely used.)

This means we should be buying US equity once we see a 10-15% correction from here – to the levels we saw in the June-July summer dip. .  

CAUTION: All this is predicated on nothing seriously bad happening in 2009-2010 (see the article – Where is the recovery -in this note). Hmmmmmm….

  • Housing prices stabilize this summer and do not lose value this winter. (not likely because banks have mountains of empty houses not on the market yet that will drive prices down when they come onto the market this winter)
  • Unemployment not becoming much worse than 10.0% (not likely – but please keep the previous article in mind).
  • The US gov’t ability to continue to run printing presses at redline (figuratively) and find bond buyers. Sooner or later this will end.
  • There will be a global stock market correction. When this happens, we’ll need people to not get spooked – sending markets down through March 2009 levels.
  • Companies will need to continue cutting expenses at the rate they have been in order to be as profitable as the forecast. Not possible for more than a few quarters.
  • The growing issue with prime mortgages failing does not worsen (it will as unemployment continues to rise). We only need a further 10-15% house price loss in order to see 50% of the mortgages in the US under water. We are likely to see prices 10% lower this winter. This has the potential to be extremely destabilizing to the economy. March 2009 stock market levels may be re-tested because we don’t know how much impact this will have on consumer confidence.  
  • The impending implosion of small banks in late 2009 through 2010 from exposure to commercial loans does not impact the banking system (FDIC in undercapitalized, so good luck). We will hit small/midsize bank failure levels as bad as the S&L crisis.
  • Nothing bad happens geo-politically that draws the US into another conflict.
  • We can extricate ourselves from Iraq in 2010 and Afghanistan (god knows when).  Wars are expensive.
  • We can figure out how to stop the ballooning costs of entitlement programs in this country. No chance. We will wait until truly drastic and painful measures are forced upon us by our creditors (China, Japan, the oil patch). 2012 will be ugly. We will then be front and center in terms of a view of funding shortfalls for entitlement programs.
  • Miraculously, taxes will have to not go up. No chance.  China will force us to raise taxes or risk them bolting on the dollar.  Good money after bad.