A Startling Earnings Report

It has been a month and a half since my last posting; and I wanted to update my thinking.

With 85% of the S&P's 500 market value having reported fourth quarter earnings, operating earnings are down 62%. That is a startling number. The drastic earnings reduction is due primarily to the financial sector's swing from profit to large loss. In previous postings I had estimated that, at some point in 2009, operating earnings for four consecutive quarters would be roughly $48. Corporations often throw in everything imaginable in the fourth quarter results. Even allowing for that, I now feel that the lowest operating earnings for four consecutive quarters in 2009 will be closer to $40 than $48. While this news is disheartening to the bulls, it does not alter the normalized (i.e., trendline)2009 operating earnings estimate of $64.

Since the second week of October, I have maintained that most NYSE stocks bottomed on October 10 at an S&P 500 Index price of 840 and the S&P 500 Index itself bottomed on November 20 at a closing low of 752. Since then, any test of these bottoms has been successful. The recent earnings news should provoke another test.

Whether that test is successful will depend on whether Geithner soon fleshes out a feasible plan to bolster the financial system. The roughly $800 billion stimulus plan to be signed tomorrow will not be nearly enough to pull us out of this recession. Freeing credit is far more important. Mr. Geithner advocates "bold" action. Bold action to me means setting up an entity to purchase "toxic assets" from the banks at a price low enough to attract private equity capital, yet high enough to persuade banks to sell. Once banks sell the toxic assets, TARP money should be made available to replenish the banks' capital. If private equity's top price is too low for the banks, then those banks which are technically insolvent should be forced into reorganization. I consider myself a believer in the free market system, but desperate times call for desperate measures.

If any test of the aforementioned bottom fails, then the next anticipated bottom for the S&P 500 Index would be in the 600 to 650 range, which would be an intersection of the trendline from the 1974 and 1982 bottoms. Until now, those bear markets were the worst since the Depression. We are in the midst of a deleveraging process that has resulted in a global recession. To be long equities, one must believe that government action will prevent a deflationary spiral. As of now, I am still willing to make that bet.