New Market Highs: What’s the Downside?

As the market reaches new highs, investor fear increases.  Much of this relates to a focus on price without regard to what has happened to earnings and the economy since the 2000 era.  How should the investor consider this?  Is the story different for traders?

One approach is to consider the downside risk.  This means more than just speculation about recession odds and the other elements of the Bear Playbook.  While no one can say with certainty what will happen with equity markets, there are ways to get a handle on the probabilities.

The Intermediate Time Horizon

Many investors and their managers operate on a time horizon measured
in months, not days. There is a lot of discussion about short-term
market moves and sentiment indicators. We are interested in a longer term
sentiment measure. The forward market P/E is good for that purpose.

We use the cap weighted S&P 500 for this purpose because
that is the vehicle for the millions of investors who buy index funds
or closet index funds. We use forward earnings because we are trying to
predict.

When the forward earnings yield on the S&P 500 is 6.7% and
the ten-year note is about 4.5%, that shows a high level of skepticism
about earnings. You can call it a risk premium, but if so, it is a big
one. It shows that the powerful voices of market bears have been heard.
Over half of the country thinks we are in a recession or about to be. A
recent online poll of investment advisors (!) showed over 25% expecting a 1987
style market crash. Wow!

Gary D. Smith calls this a negativity bubble and we agree. The
fact that an index is at a new high does not necessarily imply euphoria
using this approach. The risk premium is an objective measure which
also worked well in 2000.

Using Data on Forward Earnings

Here is a good question.  What would happen
to the market if forward earnings declined by as much as they did in
any year-over-year period since 1979 and the market got a small P/E
bump to 15.5. (That’s when the First Call series starts).

The answer: A decline of 14.4%. The biggest forward earnings
decline (almost 18%) came in the year ending with November of 2001. If
forward earnings now fell by that amount and the P/E moved to 16 (still
a very high risk premium), the S&P would be down less than 12%. It
is difficult for market to crash when so much risk is built in.

The time period includes both the 1987 crash and the 2000 bubble, so it is quite relevant.

Conclusion

The market, despite new highs, reflects a lot of skepticism.  It is ironic that the many pundits predicting recession and a market decline believe that they have had no impact.  In any market there is a chance of decline.  Meanwhile, any reduction in worries could lead to a much higher P/E multiple.

It is all about risk versus reward.  To analyze this, the investor must know what is already built into the market, not just a black-and-white doomsday scenario.

For traders, this analysis shows why there is a continuing bid under the market, even in  corrections.  Active traders who have recognized this have profited in the last month.

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5 comments

  • Mike C October 10, 2007  

    Good post, and as always food for thought!
    FWIW, I do not view myself as bearish or bullish, but more as cautious. I would not be surprised if the market was up 30% in the next 2 years, and I wouldn’t be surprised if the market is down 30% in the next 2 years. I view either scenario as plausible. Truth be told, I think the market is headed higher because IMO valuation doesn’t matter right now as much as technical and cyclical factors.
    Here is what I would say is the cautious perspective:
    I understand and appreciate your preference for valuations based on forward estimated earnings, instead of trailing actual earnings. As a side note, Graham, the father of value investing and of the “margin of safety” concept, advocated an approach of using the average of the previous 10 years of earnings.
    The problem with forward estimates is that they are, well, ….. ESTIMATES and therefore the actual future reality may end up differing significantly from the estimates at any given point in time.
    I realize that the overall economy and market cannot be directly compared to one specific industry, but for argument’s sake let’s go with that. Take homebuilders as an example. What were the 06, 07, 08 estimates back in early 2005? Did homebuilders look cheap based on those estimates? Was buying homebuilders back in 2005 based on future estimates the correct decision? Did one need to consider if forward estimates were too high? Or that the level of earnings at that time was unsustainably high?
    There is a bit of a conundrum at the present moment IMO. Yes, valuations look reasonable on forward estimates. Yes, valuations look reasonable on a 1-year trailing basis. But if you use Graham’s preferred metric of 10-year average, valuations are expensive.
    Why? Because of the magnitude of EPS growth over the past 5 years which there is simply no historical precedent for. Can it continue for another 3-5 years at this rate? I do not know. Many will argue that the magnitude of EPS growth is a function of record high corporate profit margins as a percentage of GDP, and that profit margins are the most reliably mean-reverting item in capitalism.
    Is there too much skepticism about the level of earnings as indicated by current stock prices? Maybe. And maybe there isn’t enough skepticism.
    I do think your downside risk scenario is flawed and understates the worst case scenario, but this post is getting long enough.
    In any case, one can profit regardless of their view on this particular matter. For the past couple of years (ever since the panic sell-off in Sep 2005), Berkshire Hathaway has been my (and my client’s) largest position at 30% of overall portfolio value. I view this position as being capable of participating in market upside while also protecting against downside. Berkshire is up 50% in the past 2 years, and 25% over the past year, and held up well during the market correction.
    I own other individual stocks that I believe are compelling values regardless of my opinion on overall market valuation and S&P 500 EPS prospects.
    Random Roger has recently had some excellent posts about portfolio management in terms of “being right” versus “making money”. One can make money without having to “be right” on alot of specific issues.
    We obviously disagree on some issues, but I consider you mandatory reading because of your thoughtful, intellectual style (there are some other bloggers with a hostile “in your face” style that I personally find annoying), and to try to prevent myself from “confirmation bias” and only reading that which I already agree with.

  • trader October 10, 2007  

    hello,
    Let me start off by saying this site is one of the best educational sites out there. Much thanks! My question is (bear with me because my fundamental knowledge is weak) your comment about “When the forward earnings yield on the S&P 500 is 6.7% and the ten-year note is about 4.5%, that shows a high level of skepticism about earnings. You can call it a risk premium, but if so, it is a big one”
    Can you explain why this is showing a big risk premium? From my limited understanding, wouldn’t a foward earnings yield that is still higher than the risk free yield you receive from the ten year note mean that it’s still a bullish case for equities?

  • Jeff Miller October 13, 2007  

    Trader –
    Your understanding is correct. We see the unusually high risk premium as indicative of a bullish case for stocks.
    Check out Fed Model –one interpretation of this discrepancy — in our search window and you will see many articles on this topic.
    Thanks for your comment.
    Jeff

  • Jeff Miller October 13, 2007  

    Mike C. —
    Thanks for yet another thoughtful comment. This feedback is of great value in my work.
    You might well assume that I have read Graham and Dodd and carefully follow the comments of Warren Buffett. They are giants in the field who have an important perspective.
    Having said this, there are some points to note. Graham’s work pre-dated the development of bottoms-up earnings analysis. Furthermore, the analyst estimates are much better (more realistic) now than they were in the 1999 era.
    I like to get information from as many sources as possible. The hundreds of analysts covering companies provide information that we can use. Each of us must decide how to interpret their work, but it is not meaningless.
    A company that has a new drug (or loses one), that introduces a major new product, that fails to meet foreign competition, or many other factors, show the advantage of looking forward. Using some average of past earnings gives us perfect data about the past, but tells us little about the future.
    Consider your own case of housing, a group in transition. The past three years is very poor at catching such a turning point, where analyst estimates (even if lagging) have been better. My approach has avoided housing stocks.
    If I were to tell you that my own stock picks (using my methods) have had a better performance than Warren Buffett’s since I have been managing accounts (nearly ten years) would this change your view at all?
    Thanks again for another great comment.
    Jeff

  • Mike C October 25, 2007  

    “Consider your own case of housing, a group in transition. The past three years is very poor at catching such a turning point, where analyst estimates (even if lagging) have been better. My approach has avoided housing stocks.”
    Can you expand on this? The homebuilder stocks started declining substantially well before the sell-side analyst community began to revise their forward estimates. There was a point in time when the stocks looked very cheap based on forward earnings. What in your approach led you to avoiding these stocks? It has to be more then just a valuation model based on sell-side forward estimates. My view, and I think empirical analysis would verify this, is that stock price performance both on the upside and downside leads analyst forward estimates. Most of my biggest winning individual stock picks were situations where my forward looking view differed greatly from consensus analyst projections, and my view turned out to be correct.
    “If I were to tell you that my own stock picks (using my methods) have had a better performance than Warren Buffett’s since I have been managing accounts (nearly ten years) would this change your view at all?”
    Not sure what view you are referring to? Perhaps a post on your individual stock-picking methods might be interesting to readers? There has been alot of posts devoted to the overall market, the topic of a recession, and how to digest and process information available on the Internet. A post that gets into some specificity regarding your individual stock-picking methodology might be of interest.