Trader’s Narrative

A reader, Wayne Whaley, who is also a veteran trader and registered CTA sends in this concise report on the earnings season:

“About 1/2 of second quarter earnings are in and we have a pretty good estimate now of what final earnings should look like at the end of the quarter.

With interest rates at current levels, you can make a mathematical case for P/Es in the 25-30 range

Observations:

Including the 2009 Second Quarter Estimate of 7.27, and using 979.26 as current S&P price

1) The P/E using last 4 quarters for E is 771.07
2) The P/E using last 8 quarters annualized for E is 37.21
3) The P/E using Standard & Poors estimate for 2009 earnings as E is 32.67
4) The P/E using Standard & Poors estimate for 2010 earnings for E is 26.28
5) Earnings for the third quarter need to come in around $8.50 to avoid a negative trailing one year earnings, which from the information I have would be a first (at least in the last century).

At best, you could argue that stocks are fairly valued even using estimates for 2010 earnings. Valuation techniques are interesting to calculate and make for interesting conversation but can be misleading for market timing purposes as the market can be over (1995-2000) or underpriced (1950’s) for years, especially when earnings and money supply are moving targets.”

The chart below provides perspective on the earnings collapse by focusing on 12-month, as reported S&P 500 earnings. This quarters earnings are expected to have fallen over 98% since topping in the third quarter of 2007. That makes this, by far, the worst decline on record all the way back to 1936 - the earliest we have data. In fact, real earnings have dropped so far that in the coming quarter will see the first 12-month period where the S&P 500 earnings are actually negative!

Source: Chart of the Day

While this is certainly makes for a great story that we can tell and retell to the grandkids (boring them to tears), it doesn’t really mean much. We are at an extraordinary moment in economic history. One where we are clinging to the ledge by our fingernails and peering down at the precipice below. In such unorthodox times, orthodox measures such as the price earnings ratio can fool, rather than inform you.

Often it seems our analysis of the markets are like children looking at ants through a magnifying glass. So once in a while it is always useful to take a step back and get a long term perspective. The chart below shows the inflation adjusted Dow Jones Industrial Average since 1925.

There are a lot of lessons to glean:

• While the corrections in 1929 and 1964 were of equal magnitude, the latter took much longer to play out.
• The 1960’s top (previous resistance) acted as support and repelled prices to initiate the spring rally in March 2009.
• The Dow trades at less than twice where it closed at the 1929 top.
• After more than 40 years the Dow is only trading a trifle 30% above its 1964 peak (inflation adjusted).
• Finally, the Dow managed to rise 31% since the spring rally in March 2009 - that is amazingly a pinch more than the gain from the top in the 1960’s.
• The Dow has traded in a very wide and rising trading range - so if you are really really pessimistic, you could say we are headed to 4000 (eventually)

Source: Chart of the Day

To get a full picture, compare this to the (very long term) inflation adjusted chart of the S&P 500 index.

Last summer I showed the inflation adjusted price of crude oil - below is the updated chart:

Source: Chart of the Day

It really puts last year’s crude oil bubble into proper perspective. Not only was it about 30% more intense than the 1970’s oil shock, it towers over the other price spikes we’ve seen.

What is even more peculiar is that this bubble was entirely artificial. It was not due to any geopolitical rationale, nor was it because of a supply/demand imbalance. It was entirely concocted out of thin air by large traders.

The world economy was fragile because of excess credit and speculation. Oil was the first domino to topple and knock the others down by slowing down the economy to reveal the rot under the surface. If it wasn’t the main cause of the worldwide economic slowdown, it was definitely one of the leading reasons for its severity. Although the connection needs no explanation, you can clearly see that every single recession was either preceded by or coincided with a large increase in the price of oil.

The crazy part of all this is that no sooner had the dance ended that the same players started dancing all over again. Hedge funds and large players are once again stampeding back into crude oil and commodities. After bottoming in February 2009, crude oil has doubled in price! That’s a little over 3 months ago!

And once again, there is absolutely no rationale for such a move. What? Have we suddenly lost our previous reserves of oil? is production somehow curtailed by war? or geopolitical unrest? or perhaps the market believes that the world will suddenly consume much more oil than it did before the recession?

As a trader, we don’t really care whether there is a legitimate move or manipulated by deep pockets. But at the same time, if you’re going long and letting the trend take you for a ride, just remember the difference between turkeys that get caught up in a tornado and eagles. One comes down to earth with a thud. The other soars majestically, landing at a time and place of its choosing.

When you have to look at the same chart over and over again it can get a bit boring so here’s the ‘real’ S&P 500 - inflation adjusted:

The chart shows monthly data from 1900 to February 2009 and is logarithmically scaled so that a percentage move in any year is comparable to other years. I’ve used the CPI (monthly) data available from official US government sources. Some say it is under-reported but what other real alternatives do we have? Removing the distorting effect of inflation is important for long term charts but also because we know that the Fed is doing all it can to create inflation. The most recent data shows the largest one year increase in money supply.

Like walking down your hometown streets, things look similar but different. For example, the chart doesn’t show the massive double top that is now recognized by everyone. Also, from 1900 to 1950, the market tread water after inflation. Then a roaring bull market followed, to then be deflated by an equally intense bear market.

Most interesting is that the bear market low is July 1982 - not 1975 as we usually see on non-inflation adjusted charts. This is where the bull market that followed next was launched. The inflation adjusted level of 238 acted as support, just as it had acted as resistance on so many occasions (temporarily pierced only by the roaring bull market of the 1920’s).

A similar situation is setting up today. We had a bull market that took us to new inflation adjusted levels and subsequently almost all the air was let out because the market is now back to where it broke out from the 1968 top. To be accurate we have a little more air to let out before the market ricochets off that level once again.

Assuming that this is the playbook the market is following; and if not, cheer up! we can only go to zero.