For months we’ve been listening to bulls telling us how “cheap” stocks are. They are not cheap. In fact, barring 1929 and 2000 they are the most overpriced they have ever been. But bulls point to forward earnings estimates and use a Fed Model based on interest rates that has no long term correlation to the stock market.
Hussman call this process Knowing What Ain’t True.
As Will Rogers once said, “it ain’t what people don’t know that hurts ‘em – it’s what they do know that ain’t true.” The fact is that many “new era” arguments have no provable basis even in the data of the past decade, much less in long-term historical data.
“Our empirical results show that a long-run relationship between stock indexes,
earnings and long-term government bond yields indeed exists for many countries
(including the United States and the United Kingdom) but that the long-term
government bond yield is not statistically significant in this relationship, i.e. the long term government bond yield does not affect the ‘equilibrium’ stock market valuation.
The Fed Model has no theoretical validity as a discounting model, is a statistical artifact, would never have been materially negative except in 1987 and the late 1990’s (even in 1929 or 1972), yet views the generational 1982 lows as about “fairly valued,” is garbage in data prior to 1980, and vastly underperforms proper discounted cash flow models and normalized P/E ratios. If investors still wish to follow the Fed Model, my conscience is clear, and my hands are clean.
Hussman offers charts to prove what he’s been saying. Nonetheless the arguments persists and is likely to persist as it offers hope. Repeated often enough, hope turns in to misguided belief. But the slope of hope is a slippery one as Will Rogers seems to know.
Earnings Have Peaked
The other argument about cheapness of stocks has to do with forward earnings. Few have bothered to look at why earnings were high, the quality of those earnings, and or whether or not those earnings will be repeatable.
The reason earnings were high is that consumers kept spending money they did not have, buying things they did not need. In addition, leveraged buyouts and merger mania resulted in enormous fees for brokerage houses. Neither of those was remotely sustainable, and in fact Citigroup and other are stuck with commitments to fund LBOs right as demand for LBOs has fallen off the cliff.
Chuck Prince (Citigroup CEO) is doing a different kind of dancing now than he was a few short weeks ago (See Quotes of the Day / Top Call) for more on Chuck Prince’s dancing style.
Soon to go if not gone already are debt funded stock buybacks. Those too added to profits for underwriters of debt deals.
Bear in mind that the financial sector makes up roughly 22% of the S&P; by weight and where financials lead others follow. If banks are lending, and businesses unwilling to expand, where is job growth coming from? Corporate real estate? Forget about it. Overexpansion of of commercial properties is rampant. And without corporate hiring you can kiss consumer discretionary spending goodbye.
Credit card debt is soaring but so are defaults. Some see the credit card business as the next shoe to drop. I have more on “shoes to drop” coming up shortly. For now let’s return to earnings.
Earnings Rating Game
MarketWatch is reporting Merrill Lynch lowers Bear Stearns, Lehman and Citigroup.
Merrill Lynch downgraded ratings Tuesday on Citigroup Inc., Lehman Brothers Holdings and Bear Stearns Cos., saying the trio are the most exposed among the big financial stocks to reverberations from the ongoing turbulence in credit markets.
All three saw their ratings lowered to neutral from buy, as Merrill becomes the latest to scale back expectations for big financial firms in recent days as they finetune their outlook for upcoming earnings reports.
On Monday, Goldman Sachs trimmed its outlook for the brokers.
For its part, Merrill said Bear Stearns (BSC), and Lehman (LEH) have a greater dependence on the debt markets than other firms and therefore their earnings are likely to suffer from a slowdown in the securitization and mortgage business.
Accordingly, Merrill cut its 2008 earnings forecast for Lehman by 22%, to $6.80 a share, and for Bear Stearns by 16%, to $12.07 a share.
Merrill also cut its earnings estimate for Citigroup (C) by 5%, to $4.91 a share, saying the blue chip’s broader business mix meant that any earnings shortfall should be less dramatic than at Bear Stearns and Lehman.
Consider these cuts in earnings estimates the first of many to come. No doubt, Merrill attempted to lower the bar on earnings such that companies will “beat the street” simply because that is how the game is played. But beating the street is one thing and continually dropping earnings estimates (just like we saw in the housing sector) is another.
Also today on MarketWatch today was this report: Analysts see reasons for optimism in comparing past and present cycles.
… some observers say that a widely expected rate cut should lift the sector over the short term, citing historical precedent as the rationale behind their bullishness.
Even Punk Ziegel & Co.’s Dick Bove, one of the most bearish analysts, sees a rally as possible. “An assessment of the liquidity in the financial system suggests that there could be a near-term rally in financial stocks,” he wrote in a note on Monday.
What happened in 2001?
The article cited rate cuts in October 1987, June 1995, and September 1998 as examples of markets moving positive after rate cuts. But inquiring minds are asking “What happened after rate cuts starting in 2001?”
(click on either chart for a sharper image)
A closer look at what happened after the first rate cut.
So not only are investors misguided about the Fed Model, another long battle with the Slope of Hope seems likely to begin.
Mike Shedlock / Mish/