This article was originally published on July 12, 2012 in Comstock Partners Market Commentary.
Long before it became headline news, we were talking about the corrosive effect of deflation deleveraging,excessive debt, the softening U.S. and global economy, the "fiscal cliff", the implausibility of a European solution, the probability of a hard landing in China and the prospect that corporate earnings estimates were far too high. Now these negative stories are carried in the Wall Street Journal every day and the word "deflation" is now being used by almost all market commentators. When we first brought up this word to warn our viewers about the damaging effect of the deleveraging associated with it, Microsoft Word did not recognized the word. We were asked if we meant "inflation." This week alone carried articles on downward earnings revisions at major corporations, Brazil's sputtering growth, the worsening slowdown in China, new austerity measures in Spain and Italy, the continuing disappointment in U.S. economic indicators and more worries about the fiscal cliff. As if that were not enough, the news has been full of reports on the fixing of Libor rates, the fraud at Peregrine Financial, and the J.P. Morgan losses.
In the face of the now-obvious negative outlook, the question we get most often is why the market has declined so little, and why it seems so resistant to bad news. In our view, the reluctance of the market to give up much ground is typical of many past market declines and reflects a state of denial by investors as they grasp at reasons to remain bullish. Currently, the reasons cited most often are that the market is cheap, corporate earnings are strong and the Fed, as well as other central banks, will provide all the liquidity that's needed to avert a serious economic downturn. We believe that each of those evaluations is flawed.
The current earnings estimates for 2012 are unlikely to hold up and the market is not undervalued. The consensus estimate for S&P 500 operating earnings (even though we believe "reported earnings" is the more relevent) is about $104 for 2012 and $118 for 2013. The bulls simply multiply the 2012 estimate by 15 and come up with a prospective S&P of 1560 (usually something between 1500 and 1600). Various studies, however, indicate that the more relevant method is to use a trendline estimate of reported (GAAP) trailing earnings. Our estimate of trendline earnings is currently about $75, and, on this basis, the market is overvalued rather than undervalued. The problem is that estimates of forward operating earnings are almost always wrong by a wide margin, most often on the high side. In May 2008, for instance, the estimate for 2009 was $110, and eventually came in at $57. In this regard, it is noteworthy that although the second quarter earnings report season has barely started, 42 major corporations have already guided their estimates down. (For more detail on this topic, please see our comment of April 5, 2012, "Why Valuation Doesn't Insure Against a Severe Market Decline" in our archives).
In a similar vein, we believe that investors' faith in the ability of central banks, including the Fed, to avert a serious downturn is ill advised. In 1999 and early 2000 we had the so-called "Greenspan put", which referred to the supposed ability of the Fed to avert a recession. Despite the fact that it didn't work, investors still had great faith in the so-called "Bernanke put" in 2007, and we now know how that worked out. Despite the disastrous outcome in those instances, investors now seem to have great confidence in a global central bank put. In our view, global debt deleveraging and deflation will overwhelm any central bank attempts to prevent a serious downturn, particularly when we take into account that central banks have already used their best ammunition and have to rely on unconventional and untried measures with questionable chances of success.
In the last four major bear markets the decline started very slowly from the peak, and was interrupted by numerous rallies, but continued to gather steam, ending only after a scary waterfall decline toward the end. We suspect that the same pattern may happen this time around.