Monday, May 25, 2009

David Rosenberg: "600-840 On The S&P"

"David Rosenberg can't be bargained with. He can't be reasoned with. He doesn't feel pity or remorse... and he will absolutely not stop. Ever! Until all the baseless propaganda is dead."
On a day when the U.S. citizenry takes it easy, grilling, drinking and generally doing what it is good at - being lazy, hoping that things will get better, the economic terminator who recently moved to Canada, provides a steady stream of ammunition in the fight with ignorance and propaganda. Rosenberg's morning notes from this morning are a treat. In addition to providing some critical observations on the moderation of the Fed's easing policies, Rosie highlights, as always, the debt deflation problem that the U.S. is stuck with, by observing the decline in U.S. commercial bank credit and the staggering increase in the Excess reserves of depository institutions (now at a record $877 billion, with a long-term historical average of $0 - yes, there is almost $1 trillion not sitting on some beach, and not earning 20%, in fact more like 0%).

One of the segments in the Breakfast With Dave report deals with corporate earnings, in which Rosie lays out a very good case for the ongoing market dislocation with reality and some tentative market upside/downside targets. David plays Devil's advocate and assumes a mid-cycle earnings premium to the trailing S&P500 EPS of 43, which provides for a 60% boost to earnings, concluding that in this cycle that is likely the best one can expect (and is probably rich). The caveat is that the risk to the downside is much higher as this recession is not a normal manufacturing recession, but a novel form of balance sheet recession.

Attempting a mean reversion in this new paradigm implies much more pain. As the chart below from Gluskin Sheff demonstrates, there is still likely a big drop in corporate earnings as long-term Profit-to-GDP reverts to its historical mean of 4.5% (currently at 6.6% with a peak of 11%).

As David points out, "in an environment of flat-to-negative nominal GDP, getting to that traditional trough would imply another 30% potential downside to earnings even before we can contemplate what a possible mid-cycle level on earnings would be. Plus, we could well be on our way into a double-dip recession three years from now once the fiscal and monetary stimulus is withdrawn. This happened to the USA in the 30s, and to Japan on the 90s."

And in addition to a broad based profit contraction as the economy mean reverts, another likely adverse impact on earnings, this time financials, would come from the severe credit contraction which is still in process. "The share of earnings devoted to financial activities hit an unprecedented 40%+ this cycle and has since collapsed to 14%."As this metric bottoms at around 11%, there is the threat of yet more earnings compression most likely due to credit cards and CRE.

So the EPS range is simple: S&P top earnings at $70 assuming the mid-cycle theory works, and low earnings at $50 (assuming a 30% drop from the Profit/GDP mean reversion phenomenon first forcing LTM EPS to go from $40 to $30 and then applying the 60% premium).

As for the multiple, Rosie believes the P/E should approximate a Baa bond yield, leading to an "appropriate" multiple of 12x.

Putting it all together: $50-70 in S&P mid cycle earnings, slap on 12x and you get 600 - 840 as a sensible S&P500 target. As Rosie concludes: "we know what the range of outcomes can look like: 600 to 840 on the S&P 500. On March 9th, there was much more upside; today at 892, quite the opposite." Sphere: Related Content
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