2008 was a year of extreme volatility in the markets. As measured by the VIX implied volatility index, it reached historic levels:
(click for larger image)
Uncertainty therefore, is extremely high. This is the result though and not the cause. It is a result of huge uncertainty in the markets which causes a tug of war in price discovery. That uncertainty is with respect to forward earnings and where they will be. Government intervention also causes uncertainty, but that's a separate issue from my purpose here.
Earnings are undoubtedly going to be much lower in 2009 than they are currently. It's how much lower that is the issue at hand in determining what kind of multiple to give those earnings. For example purposes, let's use the stock of a company I am currently analyzing; Cal-Maine Foods, Inc. (NASDAQGS: CALM). The following EPS history is given:
Average 10 Yr EPS (Diluted) $0.93
Average 3 Yr EPS (Diluted) $2.64
Current EPS (Diluted) $5.56
CALM's earnings are largely dependent on two factors: (1) shell egg prices (2) feed stock. Since this is only for example purposes, these factors will be excluded in the valuation. Using a simple valuation formula where a multiple is assumed in relation to earnings and dividends you can do some sensitivity analysis.
Formula: Earnings Multiplier * (Dividends per share + EPS less dividend payout)
CALM pays 1/3 of earnings in dividends. Let's assume a multiple of 12 in this example; it would result in the following range of valuations of average and current capitalized earning power value EPV:
10 Yr EPV $11.04
3 Yr EPV $31.32
Current EPV $68.66
CALM trades as of 1/9/2008 close at $30.28. Clearly, the market is expecting earnings to be more in line with the past 3 years, but is that realistic? It's hard to determine. Shell egg prices have had a miraculous run and still remain elevated while at the same time feed costs are falling. But demand is dropping from restaurants. And that's the main point I'm trying to illustrate, is that demand in most sectors of the world economies is falling.
So with that in mind, I imply that future EPV is more realistically going to be much lower than most expect, which will have a dramatic effect on stock prices in aggregate. I've clamored about this before way back in May of 2008 and the fact of the matter is the S&P 500 is still overvalued, even based on trailing earnings.
As of December 31, 2008 the S&P 500 P/E was at 19.56. Historically fair value is assumed to be around a P/E of 15. Once earnings start coming in at much lower levels than anticipated expect to see some dramatic corrections and possibly some overshooting to the downside.
Do not listen to overly optimistic analysts ranting about how undervalued stocks are, it's nonsense. In my own portfolios that I manage I have excersised extreme defensiveness and remain almost fully sidelined in cash and have been for some time. I expect to remain in cash until the carnage that earnings will undoubtedly cause plays out, at which point valuations will most likely be juicy. There is a lot of room for prices to drop based on expected earnings.
Earnings are undoubtedly going to be much lower in 2009 than they are currently. It's how much lower that is the issue at hand in determining what kind of multiple to give those earnings. For example purposes, let's use the stock of a company I am currently analyzing; Cal-Maine Foods, Inc. (NASDAQGS: CALM). The following EPS history is given:
Average 10 Yr EPS (Diluted) $0.93
Average 3 Yr EPS (Diluted) $2.64
Current EPS (Diluted) $5.56
CALM's earnings are largely dependent on two factors: (1) shell egg prices (2) feed stock. Since this is only for example purposes, these factors will be excluded in the valuation. Using a simple valuation formula where a multiple is assumed in relation to earnings and dividends you can do some sensitivity analysis.
Formula: Earnings Multiplier * (Dividends per share + EPS less dividend payout)
CALM pays 1/3 of earnings in dividends. Let's assume a multiple of 12 in this example; it would result in the following range of valuations of average and current capitalized earning power value EPV:
10 Yr EPV $11.04
3 Yr EPV $31.32
Current EPV $68.66
CALM trades as of 1/9/2008 close at $30.28. Clearly, the market is expecting earnings to be more in line with the past 3 years, but is that realistic? It's hard to determine. Shell egg prices have had a miraculous run and still remain elevated while at the same time feed costs are falling. But demand is dropping from restaurants. And that's the main point I'm trying to illustrate, is that demand in most sectors of the world economies is falling.
So with that in mind, I imply that future EPV is more realistically going to be much lower than most expect, which will have a dramatic effect on stock prices in aggregate. I've clamored about this before way back in May of 2008 and the fact of the matter is the S&P 500 is still overvalued, even based on trailing earnings.
As of December 31, 2008 the S&P 500 P/E was at 19.56. Historically fair value is assumed to be around a P/E of 15. Once earnings start coming in at much lower levels than anticipated expect to see some dramatic corrections and possibly some overshooting to the downside.
Do not listen to overly optimistic analysts ranting about how undervalued stocks are, it's nonsense. In my own portfolios that I manage I have excersised extreme defensiveness and remain almost fully sidelined in cash and have been for some time. I expect to remain in cash until the carnage that earnings will undoubtedly cause plays out, at which point valuations will most likely be juicy. There is a lot of room for prices to drop based on expected earnings.
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