Friday, January 15, 2010

Is it time to take a break from the great 'recovery'?

It appears that the economy may not be accelerating as quickly as the equity market expected or is expecting. Although we have seen improvements in different parts of the economy, the numbers remain disappointing. However, the market continues to climb higher, until today. Could reality set in at some point? Could it be that many expect the government to continue to feed everyone, including the Haitians?

Although early Q4 earnings have been mixed, we do expect overall S&P 500 earnings to come in-line or better than the current consensus. However, as we mentioned previously (a long time ago!), strong top-line growth must accompany good earnings at some point. Only top companies in the tech and defense sectors will likely be able to accomplish this as both have become necessities, literally; some through natural and habitual evolution and innovation, while others through government’s great story-telling talent.

Intel (INTC) certainly had a great quarter and provided very positive guidance. Unfortunately, JPMorgan (JPM) could not accommodate its excellent earnings with solid revenues. Other big players likely had a good Q4, but given the slightly more stable market, it makes you think whether or not companies such as Goldman Sachs (GS), very dependent on trading revenues these days, could have impressive top-line growth in 2H’10. But again, S&P 500’s 4Q’09 earnings will likely come in in-line or better than expectations.

Going back to the economy, inventory replenishment may have given some life to the economy, but will it continue? The answer of course is based on consumption, of which we have not seen much improvement, as indicated by yesterday’s retail report and this morning’s consumer sentiment.

In addition, although initial jobless claims, viewed as a leading indicator, have declined slightly, they remain well above historical pre-recovery levels. Again, Thursday’s report (1/14) supports this view.

Of course, continuing claims has been declining a bit more rapidly, but does that really make sense given that unemployment has remained high and jobless claims have stayed above 400k? The logical explanation would be that there are many more people giving up looking for jobs than there are finding jobs. Certainly, many companies have already cut down to the bone in terms of reducing headcount. As it is well-known, the continuing claims figure does not include the number of unemployed that have basically said 'no mas'. We assume those figures would be different if everyone had the attitude that those Green Bay Packers displayed last week against the Arizona Cardinals. They fell behind big but came back to make that game 'one for the ages.' Then again, that's just a game, and the football players get paid no matter what.

Although we cited the March'09 lows as the bottom, we certainly did not expect such strong recovery in the stock market. We believe that the market is currently over-valued. In addition, given the market's recovery, the notion of 'buy anything' is no longer applicable. With volatility declining (although VIX is up nicely today), we believe fundamental analysis may be rearing its logical and realistic head. We’re using the word ‘rearing’ as fundamental analysis is the last thing traders want to hear about after a great 2009.

So, let's look at valuation for a bit. The S&P 500 is at approx. 20x 2010 GAAP earnings, which could be considered fairly valued given the expectation of a 22% Y/Y growth in earnings. With not much improvement expected in consumption (although the 2010 GDP Y/Y growth consensus is near 4%, thanks to government spending and inventory build-up assumptions), we believe earnings growth for the year could disappoint and come in less than 20%. As mentioned earlier we’re confident that S&P 500 companies’ earnings would be in-line or better for Q4 and 1H'10. However, the second half of the year could be different. If companies are not successful at growing revenues, it appears that they may not be able to expand margins Y/Y further by cutting costs, making the overall 22% 2010 earnings growth a bit too optimistic. Based on a 17.5% earnings growth assumption, a 17.5x earnings multiple (PEG of 1.0), which represents S&P 500 at 1,000.00, would be more appropriate. Of course, government intervention, or that quick and short term high, could prove us wrong again. Trading along the lines of government's continuing intervention has and may continue to pay off for some time, but at some point even the government may be forced to say 'enough is enough'.

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