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Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!

Saturday, December 26, 2009

Stock Market Fundamentals -- Valuation

S&P 500 Market Tracker
This method of valuing the market rests on very long term ties
between earnings, inflation and the market's p/e ratio. The Tracker
has the SP 500 valued at 950 - 960 to wind up 2009 and at 1235 -
1300 to wind up 2010. With the SP at 1126, it is clear the market
is looking well into 2010 and is discounting continuing sharp eps
recovery. As I will discuss in the next post, the earnings indicators
do support handsome recovery next year. Readers should know that
the market will often trade at a premium to the Tracker in the
early stages of earnings recovery / expansion and that intervals of
this sort with the market at a premium can last two or so years.
The current premium over the Tracker value is nearly 18%. That
represents a sizable spread and points to significant price risk if
there is a conservative turn in investor psychology. For the record,
the Tracker did hit a cycle low of 655 for the "500" last spring
as earnings were bottoming. It matched the lows.

Valuation -- Digging Deeper
The market is discounting a return of earnings back from extremely
low levels to the very long term trend.

Investors are pricing in a sharp improvement in $ dividend payout
and expect solid earnings and dividend growth over the next 5 - 7

Investors are aware that the SP 500 has been moving over the
years to a much higher earnings plowback rate as corporate
managers have acted agrressively to accelerate profit growth. But
the p/e ratio implied by a high 65% earnings plowback rate is well
above what investors are willing to pay. Earnings growth has
accelerated since the latter 1980s, but earnings have become far
more volatile. Moreover, CEO interest in maximizing short term
earnings results has greatly fattened executive pay, but has
penalized the incomes of the rank and file and has done nothing
to add to shareholder value for over ten years. Sloppy returns on
assets deployed has led to heavy intermittent cuts in headcount
and wages to boost productivity and profit margins. True, the
development and growth of low wage emerging economies has
hurt US corporate pricing power and return on assets. Even so,
concentration on cost cutting in preference to wiser asset
management has left too many companies writing off too much
asset value and disgourging too much headcount when business
turns down. Finances within the market tell me that wiser business
asset management and higher and more stable dividend payout
would provide a less volatile and more satisfactory earnings and
market performance.

Cost cutting in the area of 25% plus moderate growth next year
could lead to a 15% return on equity for The Sp 500. A high
earnings plowback rate of 65% would imply sustainable growth of
nearly 10% in earnings over the long term. The global economy
will not support such ambition and continued CEO focus on labor
productivity to the exclusion of wise asset management will lead
to further squandering of resources that would best be dividended
out to shareholders.

In summary, investors are pricing in a standard economic recovery,
but are not now willing to pay a premium for aggressive asset
and resource management going forward and for good reason.

1 comment:

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