"All In!"--A Double Entendre

Yesterday, the October 10 lows survived the greatest test yet. The number of NYSE new lows Thursday was 776 versus 2901 on October 10; the consolidated volume yesterday was 7.6 billion shares compared with 11.2 billion on October 10. However, the S&P 500 Index did drop to a new intraday low of 819 versus 839 on October 10. As I have discussed in a previous posting, a slightly lower price (this was less than 3%lower) does not detract from my contention that October 10 marked the low for most NYSE stocks during this bear market. There has been at least one major bear market that ended in a similar way, with a breadth climax followed in a few months by a lower Index low but with far fewer new 52 week lows.

In a phrase well known to poker players, I am now "all in". I have completed my equity position started last March. I am also "all in" in terms of fatigue--hence the double entendre.

I want to make clear that an "all in" equity position for me, aged 69, is 40% of my total financial assets. The remaining 60% is in U.S. Treasury bills. Hopefully, I can sell those bills and purchase the 10 year Treasury Note sometime in the future when note yields exceed 5%, compared with 3.7% currently.

I was entirely in Treasury bills at the beginning of 2008, purchased half of the equity position in March and filled the other half during October and November. Basically, I have dollar-cost-averaged, but with only two tranches determined by my market timing approach laid out in my previous postings. The average cost of my position is roughly 1080 in the Index--not bad but should have been better.

Those of you who have read my previous meanderings have been saturated with my
claim that a measure of fear and greed rather than an earnings estimate is the better timing indicator of major market turns. The principal reason for that is that the stock market tends to bottom well before earnings bottom.

However, I have often touched on the "fundamentals". My last posting was a discussion of earnings estimates. In it I estimated that earnings for the next four quarters could drop from the high of $91.45 in mid-2007 to as low as $48 in mid-2009. "Normalized", or trendline, earnings at that time would be $64. Applying the 15 average historical price to earnings ratio to trendline earnings would result in a trendline S&P 500 Index price of 960.

The bears find that calculation ridiculous! They point out that the bear markets in 1974 and 1982 bottomed at ten times depressed earnings! (That would imply an Index level below 500!) My response is that you must take into account the level of interest rates during those lows. In 1974 and 1982, interest rates were much higher than now. The five-year treasury note was yielding 7.8% at the 1974 stock market bottom, 10.2% in 1982, and 2,3% today! Interest rates determine the rate at which future earnings and dividends are discounted to the present. A much lower interest rate results in a much higher present value.

For perspective, Goldman Sachs used to publish a table showing their "Justifiable Share Price for the S&P 500". I have one from 1994. The five-year note interest rate assumptions ranged in 50 basis point increments from 8.0% to 6%. At 8%, the justifiable value for the Index was 339; for 6%, it was 491, a 45% increase in value
solely due to a 200 basis point, or 25%, reduction in the interest rate assumption.

Perhaps a more relevant comparison would be with the 2001-2003 bear market when interest rates were more comparable. Earnings bottomed at $38.85 in 2001 and the Index eventually at 770, for a price to earnings ratio of just under twenty. At the recent intraday low of 819, the Index was selling for seventeen times my recession low earnings of $48. (And by the way, few, if any, have that low an estimate.)

In a former posting I suggested that the upside target would be the Index highs of 2000 and 2007. That double top is at 1565. The key question is not whether the Index will reach that price, but when? Here is a simplistic way of estimating. We can back into it. The historical average p/e is fifteen. At 1565 and a p/e of 15, earnings should be 1565 divided by 15, or roughly $104. Normalized earnings at mid-2009 are $64. Compounded at 7% annually, $64 becomes $104 in seven to eight years. So sometime in 2016 at the latest, the Index should reach the old highs. From the October 10 low of 840 to 1565 in 2016, the Index would have generated an 8% compound annual appreciation plus a 2%-3% dividend yield--a handsome total return indeed!

What the bears have to keep in mind is that, at some point, the market will begin acting well in the face of dreadful news. That may already have begun. Furthermore, the current dividend yield on the Index is around 3%, and treasury bills are yielding a mere 0.3%. Moreover,the five-year government note is yielding only 2.34%. The combination of these factors will ultimately lead to an episode of spontaneous combustion when the investment goal changes from "return OF capital" to "return ON capital". I wouldn't want to hold excess cash at that time.


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