A Much More Sustainable Equity Market Advance

Friday, November 05, 2010

Goldman Sachs released a great chart in October showing S&P 500 earnings per share against the index's prices. The chart tells a very interesting story about the last decade and gives some indication about what Goldman thinks this market will look like in the coming year.

Late '90s were years of multiple expansion

The late 1990s saw a massive rally fueled by enormous public appetite for anything in the technology sector, in particular any stock with '.com' in the name. At peak prices in March 2000 the S&P 500 was trading 29 times 12-month trailing earnings. Not only was this a extremely high market valuation historically it was based on unsustainable earnings. Both the 'P' and the 'E' of the P/E equation were terribly flawed.

While many huge and important innovations rose out of the 1990s technology explosion, along with it came many more inviable businesses touting entirely unrealistic expectations for growth. Valuations on a large swath of technology firms were completely out of whack and would correct once the music stopped.

Stock prices started to decline and simply didn't stop. Yet, the P/E on the market rose! Prices couldn't fall fast enough to maintain the same valuation. After dropping for a year and half and losing 26% in value the S&P ended the year 2001 with a whopping trailing P/E of 47. The S&P finally bottomed in late 2002 after a total fall of 50%.

Next rally built on shaky leveraged foundation

The next major leg up in the market was largely financed by leverage. Financial sector profits exploded driven by major legislative rollbacks that allowed for super center banking institutions and unlimited leverage for the top five investment banks. Section 20 of Glass-Steagall should not have been repealed and the 2004 SEC leverage exemption was a significant precursor to the eventual destruction seen at the top five investment banks.

Yet, much of this underlying leverage in the system went unnoticed by investors. Though, investors had learned from the technology bubble not to accept such radically high valuations based on ever-rosier and optimistic outlooks. The end of the third quarter in 2007 the S&P had a more modest trailing P/E of 19, just a month before the top in prices.

But, as the cracks in the housing market began to reverberate through financial markets, banks found themselves wildly overleveraged with now illiquid markets for their derivative securities. Stocks rapidly disintegrated wiping out 58% of their value in a year and a half.

What can the next rally look like?

After a decade of over valuations and leveraged earnings, can we enter a period of sustainable earnings growth with moderate valuations? Goldman Sachs has a 12-month target on the S&P of 1275 while they predict earnings will be $89 per share, only $2 off the all-time high in October 2007. This would result in a much more modest trailing valuation of 14x at the end of 2011 if the scenario plays out. Investors are much more pessimistic about future economic growth in the US than they have been in the last decade and are consequently assigning lower multiples.

If the valuation question is tackled, the sustainability of earnings is next to consider. The most levered names in finance are gone, namely Fannie Mae, Freddie Mac, Lehman Brothers, Bear Stearns, Merrill Lynch, AIG and Goldman Sachs and Morgan Stanley are now banks subject to leverage limitations. Earnings have dramatically rebounded fueled by capacity cutbacks across the board and a surge in worker productivity. This type of corporate cleansing has forced companies to streamline and do more with less.

With much of the leverage washed out of the system in the 2008 crash and widespread pessimism about the US economy keeping valuations muted, the S&P may be entering a period of sustainable advance in prices. Private company hiring is slowly returning and revenue growth is strengthening demonstrating that EPS growth is starting to come from the top line, the necessary support needed for continued growth.

Brandon R. Rowley
"Chance favors the prepared mind.

*DISCLOSURE: Nothing relevant.
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