S&P 500 Valuation & Expectations

One of the few bright economists, Robert Schiller has proposed that in terms of long term valuations I.e. P/E's based on 10 year trailing as reported earnings' average, is a trustworthy indicators of future market trends. I happen to agree with this methodology.

The theory suggests that markets will revert to means once they extend beyond a certain range (irrational exuberance). Historically, this range has been between multiples of 10 and 22, with an average approximately at 13 to 14. Obviously, as market psychology will certainly play a large role, undershooting and overshooting are inevitable based on the sentiments of market participants.

Using a close current price of 700 on the S&P 500, a P/E of 13.21 is inducted based from 10 year smoothed earnings. This suggests the market is rather fairly valued. However, as referenced above, the psychology of the market can prevail in moving the indexes to extremes in either direction for a period of time. Considering the extreme pessimism and more importantly, uncertainty, this is nearly assured as a highly probable outcome in the present and future.

Using a multiple of 10 as a realistic 10 year average P/E at some point in the future, we can induct that the S&P 500 can reasonably drop in value to a level of 530 without any adjustments to earnings. That is a 32% drop from current index levels. Even more alarming is that the 10 year average as reported earning level will most likely continue to decrease as each quarter passes throughout 2009. And yet still more alarming is that investor psychology can move the market lower than a multiple of 10.

While the scenario in my previous paragraph doesn't necessarily have to unfold as outlined, there is a probability it may. However, given the vast amount of uncertainty in the markets, a scenario of consolidation from this point on may only move markets slightly lower,leaving for a range bound market for several years, possibly a decade or more (it has happened in the past) until the 10 year P/E is undervalued and investor optimism returns.

The variations of how the future may unfold are infinite. However, the probability that a still sharp fall in the S&P 500 is indeed not to be ignored, and neither should the second scenario. In either case, with no real boom like productive capacity in our economy and massive government intervention, I suggest a very high probability that despite a sharp fall in the S&P 500 could still unfold, there is no reason to expect a sharp reversal in trend to the upside for a sustained period of years, that is a secular bull market. Instead, I deduce a long term consolidation period of misleading ranges will be the likely outcome for some years to come. A buy and hold strategy will lose you money in the next decade.

Debt Overhang Hauntings; What Ails Bernanke's Sleepless Nights

The ignorance (or evil cunning) of our politician's today are fooling no one with their band-aid stimulus plans that don't even stick. Stock market indexes have confirmed the lack of faith in the ability of "big brother" to step in, just look at last week's chart of the ^DJI:


In case you were wondering that chart reflects a loss of 420.46 points for a 5% loss in a single week. This all occurred in real time as Geithner, Obama and other political "superstars" such as Barney Frank unsuccessfully tried inspire confidence in their proposed "stimulus" plan. What about other markets:

I highlighted in red the change form last month, which reflects a huge reversal in confidence in the government to fix the problem by issuing nearly $1 trillion in bonds, bills and notes, which inspires the ultimate fear play:



Gold has been rising dramatically in the past 30 days. So why the sudden mistrust in treasuries after their position over the past several years as a safe haven? The following charts help explain:

The above chart is a bit fuzzy (my apologies) but it paints a clear picture. The US has managed to leverage itself in both public and private debt 3.5 to 1 (as of 3/31/2008). Considering the explosion of government spending since then, this figure has grown even more. Furthermore GDP is shrinking.

Now there is criticism out in the financial community that a bit of double accounting exists in the total debt figure for this chart, but regardless the message is clear. A few more charts should help convince anyone that there is a real debt problem of "unprecedented" magnitude:



Americans are deleveraging right now at historically low interest rates, yet debt levels are so high that debt service to income is 3% higher than the double digit interest rate environment of the 1980's. What happens if interest rates spike? Of course we know, the economy completely tanks as defaults spike.

What ails Bernanke at night is that he must know that there is only one realistic outcome of this crisis that leaves him utterly powerless. Consider the hyperinflationary outcome from outright monetization of all this debt. Interest rates would spike, commodoties would soar and public and foreign government outcry would ensue. Bernanke couldn't possibly consider monetizing all this debt because as a result the dollar (the world's reserve currency) would lose its standing and foreign governments would lose all faith in the American economy. This loss of power is a far worse scenario to the Fed and politicians than a deflationary depression.

Now after reviewing all the above charts, how can politician's like Barney Frank continually call for banks to lend?

Here is the scenario: The Fed was not the actor but the author in this modern day opera, fractional reserve banking the main character and credit the dominant factor.

Yes there were many other actors; the rating agency cartel, securitization markets, govenment intervention, etc. However for all intensive purposes these are political sideshows and every call from representatives like Barney frank for reform of these actors will be welcome, but will not solve the underlying problem which is the credit based monetary system itself.

It follows as such; once a credit boom ensues the availability of productive investment dwindles, which leads to malinvestment namely in asset speculation (bubbles). Entrepreneurs are specualtors in nature and is not necessarily a bad thing, but the excesses of credit disort expectations on rates of return, which leads to irrational credit induced booms which are ultimately unsustainable and will come crashing down once the rate of credit expansion slows.

This has already been underway for some time and there is nothing anyone can do unless they sacrifice the credibility of our entire economy by monetizing a truly massive amount of debt outstanding. The only reasonable outcome is the necessary purging of debt that must occur.