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what started as a range-bound market in2000 will turn into a bear market, giventhe high valuations that are in place.Let’s try to figure out the earnings power of the S&P 500. The current 2010estimates of its operating earnings are$75. I am skeptical of this number for several reasons.First, it is nearly double the reported2010 earnings estimates of $45. The percentage difference between reportedand operating numbers is the second-highest since 1988 (2008 holds therecord). During the 2001-2003 recession,the difference was about 50 percent. “One-time” write-offs are responsible for thedifference. It is very likely that these “one-time” charges are not really “one-time”;thus, operating estimates overstate the trueearnings power of the market.Second, 2010 estimates are onlyslightly below the all-time high earningsthe S&P achieved in 2007, when our economy was under the influence of several bubbles which severely inflatedcorporate profit margins to unprecedentedlevels. Also, the bulk of excesses inmargins in 2007 came from the financial,materials, energy, and industrial sectors— the ones that are struggling today and willcontinue to do so for a long time.Finally, if earnings were to be as projected, we’d be following the lastrecession’s recovery path, which is unlikely.The last recession was corporate, whilethe current one is riddled with debt-ladenconsumers. Deleveraging the excesses of the housing bubble, in the face of higher future taxation and likely higher interestrates (both byproducts of large deficits),will be a lengthy process. The recovery will be slower, and real earnings growth will belower than in previous recessions.It is hard to know the exact earnings power of the S&P 500, but it likely liessomewhere in between operating andreported earnings estimates, and thuscloser to $60. This would put the P/E of the S&P 500 today at about 19.Since 1900, stocks have spent verylittle time at what is known as a “fairlyvalued” P/E of 15. In fact, they have spentless than 27 percent of the time between P/Es of 13 and 17. They only saw a P/E of 15 when they went from one extreme toanother. Most importantly, they’ve never stopped at the average and gone the other direction; they’ve continued their journeyto the other extreme.During secular bull markets,investor optimism, bundled with constantreinforcement from rising prices, takesstocks to above-average valuations,causing P/Es to expand beyond their long-term average. P/Es can shoot for the stars, but they don’t get there—at thelate stages of the secular bull market,P/Es stop expanding. As earnings growth becomes the sole source of returns,disappointed investors start diversifyingaway from stocks into other asset classes,and a range-bound market ensues. As therange-bound market marches on, unmetexpectations reinforce disappointment instocks, and P/Es are compressed to theother extreme. Keeping this in mind, notethat stocks are still not cheap, and thusrange-bound markets still lie ahead of us.Interest rates and inflation aresecondary to psychological drivers, butthey’re still important. They don’t causethe cycles, but they do help to shape their duration and the valuation extremes thatstocks achieve. For instance, if, at the endof the 1966-1982 range-bound market,interest rates and inflation had not beenin the mid-teens, the range-bound marketwould have ended sooner, at higher P/Es.On the other hand, if, in the late-1990s,interest rates and inflation had not beenscraping low single-digits, the bull marketwould have ended sooner and at lower P/Es. The higher inflation and interest ratesthat are around the corner will take their tollon the duration and final P/E of this marketas well.
What Investors Should Do
In range-bound markets, as P/Escompress, they turn against investors. Inthis difficult environment, investmentstrategy needs to be adjusted for the newinvestment reality. Here are things thatinvestors can do:Become an active value investor.
Traditional buy-and-forget-to-sell (hold)strategy is not dead, but it’s in a coma,waiting for the next secular bull marketto return, and it’s still far, far away.
is not just another four-letter word; selldiscipline needs to be kicked into higher gear.Increase your margin of safety.
Typically, value investors seek protectionfrom overestimating the “E,” earnings. Inthis environment, protection needs to be
Napfa advIsor aprIl 201024