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1 The Firecracker Report
We invite you to read more on our blog The Firecracker Report
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Is the S&P 500 in a Top Formation?
As we enter the closing month of 2009, the S&P 500 has rallied 66% off its March 2009 lowof 666, and it is now just 200 points shy of its pre-crisis trading level of ~1,300 (August-September 2008).Heading into 2010, most investors are trying to understand what the future has in store forthe equity markets. Is there still plenty of room left to the upside as Cramer from the CNBCbull pen would like us to believe? Is this the beginning of a new bull market where the S&Pwill clock >20% annual returns over the next few years? We think not, as we explainbelow.
Wall Street’s Best Case Scenario
- S&P to Trend Flat in 2010 and Take off Like aRocket in 2011
As of now Wall Street‟s most bullish scenario bakes in a flattish trend in the S&P 500 for
2010. Consider Chart 1 below, which plots out the annual S&P EPS on a LTM (last twelvemonths) basis on the left axis, along with the closing year-end value of the S&P on the rightaxis. As per Wall Street estimates (which are way too optimistic in our opinion) S&P 500earnings will grow 14% in 2010 to $53 and a whopping 28% in 2011 to $68. In other wordsWall Street has pushed the V-shaped recovery further out by a year to 2011.So where would this leave the S&P 500? If we apply a bullish 21x P/E multiple (the averagemultiple from 2003-2007 was 20x and those were the good years) to these very bullishearnings we arrive at a value of 1,113 for the S&P in 2010 and 1,423 in 2011. In otherwords the Streets 14% EPS growth for 2010 is already baked into the current trading levelof the S&P of ~1100. Beyond 2010 the Street is expecting a sharp recovery in both EPS andthe S&P so that they each rally by 28%.
Chart 1: S&P 500 annual EPS (actual and Wall Street Projections) plotted withrespective year-end closing S&P values.
 
 
2 The Firecracker ReportLooking at the chart above one would be tricked into thinking that the EPS growthprojections look pretty promising except for one key fact: Most of the EPS gains in 2009came not from revenue growth but via massive cost cuts and lay-offs as evidenced by thenearly 10% official unemployment rate. So for the S&P to grow its EPS by 14% next yearand 28% thereafter, it would have to show some real revenue growth and profit marginexpansion because companies have already cut costs to bare-bone levels. And it would haveto achieve all this 1) without the credit gasoline that fired the consumer and corporateengines in the 2001-2007 cycle, 2) with a persistent >10% unemployment rate, 3) Withoutthe housing asset bubble as an ATM and 4) In the face of soon to be the norm capital and
trade controls which will have to be imposed as the world‟s central banks race each other to
devaluing their currencies (think goodbye export growth to China, India, Europe and Japan).An impossible task.
A Bear Market Rally with a Twist
In our opinion this continues to be a bear market rally but with a twist. This rally wouldhave fizzled long back had it not been for the enormous amounts of money that the Fed haspumped into the system particularly large financial institutions. In the absence of suitablelending opportunities, all this money has found itself speculating in the stock and thecommodity markets.
So unlike bear markets in the past, this time the Fed‟s intervention has
been so massive (to the tune of trillions of dollars) that it has kept the markets buoyedhigher and for longer.So how would this rally fizzle? Not in the way one would normally imagine - i.e. animmediate sharp move lower (it could happen but it would be a low probability event).Instead, as we show in Chart 2 on the next page, it appears that the S&P is in for aprolonged period of forming a top. Justin Mamis captures it best in his newsletter:
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The stock market is becoming increasingly familiar. We've seen this before (or lesservariations thereof). This is how an important top forms over a long, very long period of time. It took over a year for the '07-'08 top to evolve -- from spring '07 at about Dow11,000 to the breakdown in the summer of '08 in the neighborhood of 11,750. And this rise,remember, is to a secondary lower high
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Market timing has nothing to do with the daily news, because it truly is anticipatory, nomatter how much daily news items, such as pennies-better-than-expected earnings reports,are embraced as glorious."Friday's seesaw 'up' on the so-called employment report, and 'down' when that childlikeburst of enthusiasm was exhausted, is but one day in the gradual ebbing of the extensiverally -- 10 months in duration and still incomplete . . . although, of course, 'tis getting laterand later.. Not only is the economic news and the financial news calming (and indeedencouraging), but the lack of selling pressure makes the market look benign. "Replete with
 
 
3 The Firecracker Reportoptimism, tops therefore really do take a long time to form, and to form in seemingly 'safe'ways
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Chart 2: The first chart shows a 5 year performance of the S&P 500 with the redcircle highlighting the prolonged the topping out pattern from 2007-2008. Weexpect something similar to occur now. As highlighted by the green circle in thesecond chart, the S&P has been trending sideways since its mid October peak of 1,098. Since that peak the S&P has risen a mere 5 points to close at 1,103yesterday.
Thus in conclusion, we expect the market to map out a top formation pattern going into2010 before trending down (once folks can better ascertain the trend in the EPS for 2010and 2011). In such a scenario investor portfolios should be defensively positioned in highdividend paying stocks, many of which have not participated in this rally to the same degreeas the speculative paper.
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