Stock Values Reasonable; Not Historically Cheap

The latest numbers from corporate America are abysmal. After AIG's record loss, the as-reported earnings for Q4 went to -$20 for the S&P. This magnitude was unanticipated by analysts and is the worst in history.

The all-time average 1-year trailing S&P PE (net, not operating) ratio is 15.32. As of right now at 676 the market's PE is 19.41 [Shiller's stock data]. Taking a much longer view using a 10-year trailing PE average of 16.34, the current value of 10.86 offsets the shorter term indication because it considers the high levels earnings of the past decade. It's hard to believe that after going down 55% since 2007 stocks are still historically just fairly priced and arguably still expensive, but that appears to be the case. Unless debt-related writedowns are over and the non-financial world bounces back hard, the S&P could settle to 500 later this year. Q1 would have to exhibit unexpected resilliency to prevent fundamentals from deteriorating further.

Abby Cohen and Nouriel Roubini project S&P earnings at $50-60 for 2009 while Standard & Poor's projects $64 (these are operating and not net earnings), but another season of misses is within the realm of possibility. Media outlets such as MarketWatch are putting out research that concludes stocks are cheap. In this author's opinion these articles are not necessarily wrong but do a disservice to readers who jump to the conclusion that stocks will go up based on relatively low valuations. In a recession in which net earnings have decreased 40% faster than from 1929-1931, the most likely scenario is even lower valuations until the earnings trend reverses.

Andrew B., a financial planner in Memphis, tells me he has large clients who are throwing in the towel. Aaron P., commercial property manager for Loeb Properties, says some of the REITs are in big trouble. Pension funds are de facto insolvent and might need to raise cash. Hedge funds are still processing massive redemptions. Companies aren't giving guidance anymore because they know what is happening to their revenues and they don't want to propagate unnecessary fear in their stock prices.

Short term sentiment is approaching an extreme -- although not according to SentimenTrader -- and a few smart people like Marc Faber and Charles Kirk are expecting some kind of rally in stocks, so this analysis could be ill-timed. But given the earnings and valuation outlook there is little fundamental support for the S&P going further than 750-800 before sellers decide earnings are too unstable. The one piece of ammo the government has left to cause an artificial rally in stocks is suspension of Mark-To-Market accounting. This controversial topic could be debated in Congress soon, although the effect of this could be muted as CNBC hosts have already latched onto the idea that it will be a big catalyst for buyers.

Previous Support Pattern: A Short-Term Model

Price patterns have limited value in predicting the future but they are a great indication of what is normal. Consider the behavior of testing previous support in extremely bearish markets.

I conclude that the next big rally to 750 or 800 is vulnerable and shortable. The toughest thing to do will be predict the point where that rally starts. The easiest thing to do will be enter the position and stay short even from levels that seem low until the economic indicators are clearly recovering.

Eric Winchell
Capital Currents