Our Take on the New Normal - Adjust for Downside Risk Now

Aug 12, 2010
Author: SCP Editor

August 12, 2010 - We continue to think that the Street has already priced in, if not overpriced in, the impact of relatively strong earnings season. It has, up until yesterday, been largely ignoring the implications of all of the negative economic data we have been getting.

·         Retail sales lagging as consumers are spending less. MasterCard Advisors SpendingPulse reported this morning that U.S. retail sales rose 0.1% in July from June. Excluding autos, sales fell by 0.9%. On a year-over-year basis July sales ex-autos were up1%.

·         Housing market remains in disarray. Realty Trac said this morning that foreclosures increased again in July. Banks repossessed more than 92,858 properties in July, up 9% over the previous month and up 6% in the year.

·         The labor market is a mess. This morning’s weekly jobless claims report, once again, was worse than expected.

There can be no economic recovery in an economy which counts on consumers to represent 70% of GDP, when that economy has lost 8.5 million jobs and is close to 10% unemployment. In this environment consumers will predictably slow their spending. GDP will predictably contract, and potentially grind to a halt.

Add to this dynamic the fact that there is really very little the government can do without making the situation worse, either in the short term or the long term. If the government opts for the populist-driven near-term relief, it will continue with stimulus (debt) spending measures and policies. But with the national debt approaching $14 trillion, and 100% of GDP, we run the risk of throwing our economy off the rails if the U.S. loses its AAA rating.

If the government does what it needs to do (our opinion), and focuses efforts on nursing the economy back to health by cleaning up its balance sheet, shifting policy to emphasize more export  business and more domestic manufacturing and less on a reliance on consumer spending, then we can expect a prolonged period of slower, if not anemic growth while the U.S. economy’s fundamentals hopefully stabilize – the ‘new normal’.

What the populists don’t admit, or realize, is that it is probably going to be the case that this is unavoidable. Even if they throw stimulus measure after stimulus measure against the wall – whether in the form of cutting taxes or printing money. The disingenuous component of the populist argument is that any tax cuts would not be paid for any way and would just add to the debt. This is a discussion that most folks in Washington either don’t want to have or are totally missing the point on.

Against this backdrop, we will continue to remain cautious. We think there needs to be a shift in thinking about valuations – unfortunately. In the ‘new normal’ , a price-to-earnings target of 14x (the historical average) the S&P 500 is probably wishful thinking. In the ‘new normal’ it is probably going to be closer to 10x.

We also continue to think that the Street is over-optimistic about FY10 expected earnings for the S&P at $82 to $85. We think the number will likely be closer to $70. If we are right on these points, at yesterday’s closing price, the S&P 500 is trading 15.6x earnings of $70 and looks topped out. The consensus view would have the S&P trading at 13.28, still not exactly a depressed asset range.

If we are right about the inevitable adjustment to valuations under the new normal, a 10x trading range for the S&P 500, assuming $70 would put the index closer to 700, a serious leg down from the current 1,089 level. Even at $80, it would put the index closer to 800, which represents about 26% downside risk.

In our opinion this scenario is not a question of ‘if’ but ‘when’ and we would caution our readers to stay sober and not get caught on the wrong side of this trade when the Street gets around to doing the math.

To be sure, this last round of earnings reports was pretty solid, demonstrating that companies are doing a good job managing their cost infrastructure. But they are hoarding cash. In this market, for a public company, it is easier to borrow money (at historically low rates) for stock buybacks to window dress solid earnings than it is to find the intestinal fortitude to start hiring again, in anticipation of consumer demand