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The Flounder Economy

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April 15, 2009 – Comments (6)

 

I came across an interesting article by Tom Au this morning.  Despite his association with thestreet.com (yuck) he makes some very interesting points that I agree with.  The first pertains to how large a percentage of the S&P 500's earnings came from finance, i.e banks, investment banks, the financial arms of industrial companies, etc... in the not so distant past.  According to Au, a whopping 40%, or $32 of the $80, of S&P 500 earnings came from finance. 

Much of that earning power has disappeared and might not be coming back for a while, if ever.  The evaporation of most of this financial earning power alone without any sort of recession would drop S&P 500 earnings to the $50-something level.  On top of that, a decent chunk of the leftover non-financial earnings were larger than they should have been because of the housing bubble and unsustainably low consumer savings rate.  Au uses what he believes is a conservative estimate of $5 for the bubble-effect, putting the normalized S&P 500 earnings rate at around $50/share at best.

Applying a historical multiple of 14 to 16 this $50 yields a range of 700-800 for the S&P 500.  That's lower than the 840 level that it currently sits at, but not a complete disaster.

The problem is that in my opinion, this 700 to 800 range for the S&P underestimates the devastating impact of the current recession.  Furthermore, I believe the proverbial "animal spirits" may be depressed for some time to come by people who have seen their net worth fall dramatically.  If this is the case, we may not see an earnings multiple of 14 to 16 for a while.  If S&P earnings do fall to $50/share and scared investors are only willing to give a 12 multiple to that, we're talking about a target of around 600 on the S&P 500, below its recent low.  And this assumption isn't even that pessimistic.  It's a lot better than the multiple of 6 to 8 times that Au thinks that we might see.

Here's a great quote from the article:

The problem comes at payback time. For instance, much of the borrowing was tied to the housing market, on the bogus theory that houses could be made twice as valuable (as a multiple of rent) as they were for all of American history if prices could be kept on steady incline. The problem was that valuations collapsed when house prices fell, or even failed to rise, bringing down the market with it. To make up the shortfall, the U.S. economy now has to consume less than it produces, for a time.

I'm not as bearish as Au but he makes some very valid points.  I don't know if the major indices have already seen their low or if they will eventually fall through it, but I certainly would not be surprised in the least if they did. 

Either way, I don't expect the U.S. economy to experience rapid growth for a while.  I think that we are in a period where earnings will eventually bottom out in 2010 and flounder, flopping around in a range at the bottom for a while like a fish out of water.  This is why I have been investing for yield.  I want to be paid cash by the companies that I invest in, not cross my fingers and hope for capital gains based on rising earnings or multiples that may never materialize during the coming period of slow to no growth that I expect the U.S. to experience.

Deej

6 Comments – Post Your Own

#1) On April 15, 2009 at 12:05 PM, catoismymotor (36.23) wrote:

I have reached a similar conclusion about the short term (five years) of our economy. What I have done is arrange my portfolio to contain 60% American stocks, of mostly solid small caps with wide moats. The remaining 40% are made up of Chinese companies, again with wide moats. It has taken me six months of reseach to wittle down the exact companies I want and how to allocate the funds between them. With my strategy I hope to capture the greater short term growth with the Chinese companies (five to ten years) and reap the long term rewards from the Americans (twenty plus years).

BTW: I like to fry my flounder in a beer batter, serve with hushpuppies, coleslaw and potato salad.

 

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#2) On April 15, 2009 at 12:27 PM, dudemonkey (39.98) wrote:

The remaining 40% are made up of Chinese companies, again with wide moats.

How wide of a moat can you have when the government can wipe you out at any time?  I've been looking into Chinese stocks for a while, but haven't really been able to parse their culture codes yet and it seems that the government is the overriding factor in China. 

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#3) On April 15, 2009 at 12:46 PM, tonylogan1 (27.87) wrote:

Instead of trying to find the few companies that actually go up. I have been enjoying selling index options, where I make money if the market goes down or stays flat. With the expectations you have, wouldn't you think it would be better to sell LEAP option spreads and collect the premium?

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#4) On April 15, 2009 at 1:35 PM, leohaas (32.04) wrote:

I love flounder, especially if stuffed with crab...

More to the point, if this analysis is correct (and you don't hear me disagreeing), then buying some of the inverse ETFs is a good idea. Or even better, go for the 2x or 3x inverse ETFs. The Fool has an excellent page on ETFs.

One warning though: don't treat these ETFs as a buy-and-hold investment. You have to be ready to sell them quickly, so only go there if you follow the market daily.

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#5) On April 15, 2009 at 2:09 PM, catoismymotor (36.23) wrote:

Dudemonkey,

I've been doing the research for six months on the Chinese stocks.  I have been swayed from "Oh, I would never buy a Chinese company." to "Just look at the opportunity!"

I understand that you have concerns that the ghost of Mao will rise up and take all the goodies for himself. I believe that China is happy to let all non-commodity companies do their thing, so long as the taxes are paid and rocket fuel is kept out of the baby food.

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#6) On April 15, 2009 at 10:27 PM, outoffocus (22.86) wrote:

MMmmm...Flounder *drools*

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