Stock Market -- Earnings & Long Term

It appears that the 12 month operating earnings of the SP 500
could well fall 50% or more peak-to-trough in this cycle.
Specifically, net per share could fall from an all time high of more
than $91- to $45- or less by later this year. The post WW1 era and
Great Depression saw larger declines, but the present downtrend
is as bad as it gets short of economic catastrophe.

As you might imagine, steep declines of corporate profits are followed
by strong advances once the economy turns positive. Even so, with
a decline of 50% in net per share, experience shows it could take
5-6 years to recoup and see earnings move to new highs. This
observation suggests that the recent $91- peak might not be topped
until 2014-15.

I do keep a model of the SP 500 based on very long term net per
share growth of 6.45% and a p/e based on both a long view simple
average of this ratio plus one based off long run inflation. Trend
or "normalized" eps for 2009 is about $75- and the p/e ratio is
set at 16.0 - 16.5x. The model value thus has the "500" at 1200 -
1238. Thus the market, now in the mid-700s, is very reasonable
against the long term framework. But, to be realistic, it could well
take several years to see reported "500" eps back up to $75-. Thus,
you need to take the model's output as a measure of value and not
a shorter term price target. But, you also have to recognize that
development of a cyclical bull market in the wake of a very deep
decline of earnings can easily double the price low within 4-5 years.

Now I can use historical earnings and dividend data to construct
a more muted price recovery as well as one with even more punch
than that outlined just above. Much will depend on the power of
the economic recovery as well as how aggressively companies
manage their plowback of earnings and their balance sheets.

The long term model I discussed above is quite a bit more
conservative than the one that served me well from the 1985 -2007
period. I have taken the long run trend of earnings component
down from 8.5% back to the historic 6.45% in looking toward
the future. I also used a 70% earnings plowback rate with the
1985 - 2007 model and this could be high going forward. But we'll
have to see on that.

I use a long run "normalized" pattern model to try and envision
the future and as a diagnostic. The LT model of the SP 500 is
different from the Market Tracker, which relies on current 12
month earnings rather than points on a trend. If 12 month "500"
net per share drops to $45- this year as expected, the Tracker
would show a value of about 740. Grim indeed.

I plan to set the longer term stuff aside for awhile to focus more
on the shorter term environment. After all, the economy still
sits at the edge of far more serious trouble, and I need to check
in on whether my view that we can avoid catastrophe has some
merit.