I See Nothing But Delevering In The Future!

I see nothing but delevering in the future!

But, is that necessarily bad?

It all depends upon valuation.* If valuations are low, then future returns are likely to be high. If valuations are high, then future returns are likely to be low.

So, where are we at? Based on future earnings, valuations are significantly below the avg. PE of the last 25 years, and a little below long term avg. multiples. The question then becomes, how confident are you in future earnings expectations, and what do you believe the market is likely to pay for earnings in the future. I'm pretty skeptical. Earnings expectations seem a little (make that a lot) optimistic to me. But if they are close to reality, then valuation is in the middle of the range, and returns will mirror earnings growth.**

Of course, economic, social, and political distress are likely to weigh negatively upon multiples. And I see lots of economic (and likely some social/political) distress in the future as governments and consumers are forced to delever and the fissures in the system are put to the test. If the deleveraging process doesn't happen (and we continue to prop the system up with fiscal and monetary stimulus), then financial armageddon is all but assured. But, in that situation, we could cruise along for a few years before the wheels completely fall off.

If I am anywhere near the ballpark, then that confluence of factors could easily see the market trading at a trough multiple of 10 against normalized earnings of $60, translating into a level of 600 on the S&P 500. Such a bearish scenario goes up against the following positive drivers: global economy now on the positive side of the cycle; the natural inertia within the system; the basic resiliency of people and economies; the emergence of the third world; the chance that true political solutions are put in place; and, the potential for multiple expansion based on positive developments.

*One of the best things going for the market at the moment is the fact that we experienced a reset in asset prices back in 2008-09. The critical element in valuation, and consequently the related return, is the multiple the market is prepared to pay for a given level of earnings. If it is higher than todays present multiple, then in all likelihood, returns will be positive. If lower, then returns are likely to be sub-par.


**Much in the same way that asset prices were reset in 2008, so to were earnings levels reset. Long term earnings growth is between 4%-6% pa. With us coming out of recession it is probably not unreasonable to expect earnings growth a little higher than the long term average growth rate.

Choppy Markets

Choppy markets. More careful navigation required. May want to book some of those accrued profits.

The markets are sending up signs of discontent. Greece/Eurozone crisis, flash crash, silent Chinese meltdown, Gulf oil spill, falling interest rates, Euro decline.

I'm looking to a faltering of the Consumer Discretionary sector and SMIDs vs large caps relative performance for signs of trend reversal and changed sentiment/risk appetite. We've seen a few inklings, but no real break, yet.

The summer doldrums could give way to hurricane season, although most of the fundamental action is not likely to play out until 2011.

Strategas reckons we've got the greenlight until fiscal/monetary withdrawal becomes a closer reality. Possibly. That would mean we continue to party in 2010. Time will tell, as they say.

Stay tuned.