The Ugly Muddle-Through

Goldman Sachs (GS) published a report Thursday in which they suggest the most probable scenario for the next 12 months is GDP growth between -0.25% and 0.25%, or basically zero. Wayne Angell, mentioned above, expects the second half of ’08 to be no better than the first half and for GDP growth to be 1%.

In the Bridgewater report mentioned above, they estimate that the net worth of US-based assets is down about 13% since January 2007, a total loss of almost $8 trillion. This is hitting pension plans, corporations, and consumers, making them think twice about planned investments and expenditures.

Earnings estimates are being cut with each passing month. The P/E ratio for the S&P 500 is currently at a sporty 23. Historically, in times of rising inflation, the stock market goes through “multiple compression.” That means P/E ratios fall more than earnings. If multiples fell just 20%, back to 18, which is still above long-term trends, the market would see another 20% drop from here. Even with earnings growth, the market is going to have a challenge rising in the current environment.

Sidebar: A number of you have written questioning my source for the P/E ratio, as you read or hear different numbers from what I write. You can indeed find estimates of forward P/E ratios as low as 12 a year from now. That is a lot different from the 23 I cited above.

There are two basic types of earnings that are reported. One is “operating earnings,” or what I call EBBS, or Earnings Before Bad Stuff. Then there is “reported earnings,” which is what the corporations report on their tax forms. Not all that long ago, in the mid-’90s, operating earnings and reported earnings were generally in line with each other. Companies would deduct genuine one-time, unusual losses from their reported earnings to give us operating earnings. And such a system has a valid basis for existence. If something is truly one-time, maybe an investor should overlook it when evaluating the company’s potential.

But then the media and analysts started using the operating earnings as the primary number, and companies began to game the system. More and more items were considered one-time. One of the more egregious examples was when Waste Management Systems declared that painting the garbage trucks was a one-time extraordinary expenditure and should be accounted as such. Today the difference between as-reported and operating earnings can be 20-40% or more! It seems there are many losses that management assures us are just one-time items.

Standard and Poor’s has a webpage where you can see a spreadsheet of historical data and projections for both types of earnings. That is the source of my data.  .

Analysts’ estimates do tend to get brighter the further out one looks on the table. But if the growth scenarios mentioned above come about, and banks have to curtail all sorts of lending, the earnings projections are going to be way too high, as they have been for the last 12 months. That is going to mean more pain for the stock market.

I think it is quite likely we see the Dow slip below 11,000. (Ok, I wrote that Thursday!) As I said on Kudlow the other night, another 10% drop in the market would take us only to the average bear market. A “9 handle” on the Dow seems quite possible, if not likely. (Note: when someone says “a 9 handle,” they mean that the first number in the index or stock price is a 9. The first number is the handle.) The risk is to the downside, given the tepid potential growth of the economy.

Once Again, the BLS Numbers Paint a False Picture

I almost get tired of writing this each month, but it is important, and I will do it quickly. The unemployment number from the BLS last week showed a loss of 62,000 jobs. Private sector jobs were off by 91,000, with the government showing growth of 29,000.

But once again, the birth/death ratio of estimated new jobs was 177,000. As The Liscio Report noted: “… without the b/d's contribution, private employment would have been down by something like 268,000. It added 29,000 [new jobs] to construction, 22,000 to professional and business services, and 86,000 to leisure and hospitality. Given the weakness of the economy and the crunchiness of credit, we doubt that there are enough startups around to match these imputations.”

Revisions to the prior two months were a negative 52,000. When they do the final numbers a few years from now, we will find that the revisions will be in the hundreds of thousands for the first half of the year. We have now had five consecutive months of downward revisions, which is typical of recessions.

Unemployment held steady at 5.5%, but that masks an underlying and growing problem. There has been a huge increase in the number of people working “part-time for economic reasons” and a large number of people who are discouraged and not looking for a job but would like one. These two categories are not counted as unemployed. If you add them into the equation, the unemployment or underemployment number goes to 10.3%! (per Greg Weldon)

As I warned above, this has not made for pleasant reading. But it’s reality, and we need to deal with it.

And let me say that even given the above, I am a long-term (and even mid-term) optimist. We have to work through some serious problems, but we will. Valuations are going to be low once again, and it will be time to become bullish. And researching and writing my book on how the world will change in 20 years makes me very optimistic. No one in 20 years will think of today as the “good old days.” The changes that are in front of us will be amazing. So, simply take a deep breath, be conservative today, and get ready for a really wild and fun ride.

And speaking of investment banks, I need an introduction to someone who’s deeply involved in the creation of Exchange-Traded Notes. Drop me a line.

Las Vegas, Maine, and a Wedding

I am at Freedom Fest in Las Vegas, and want to hit the send button so I can attend the sessions and see a lot of old friends. I really think it will be good fun. I have dinner with Frank Holmes of US Global tonight, and look forward to it. Frank is the consummate gentleman and always very interesting.

And speaking of dinner, I was with Barry Ritholtz (of Big Picture fame) last week, and we agreed we are psyched about going to Maine at the end of the month for David Kotok’s annual fishing extravaganza. Lots of good friends, wine, and conversation – and I will get to collect on at least one of the group bets we made last year predicting markets, etc. And I was way wrong, but everyone else was even more wrong. Go figure. I will tell you all the details after the trip.

Daughter Tiffani’s wedding is getting closer: August 8, 2008. Less than a month, and a lot of coordination to be done. It is at the point where I am sitting in on meetings. Flowers cost what? Fireworks? Credit lines are being squeezed. But it is going to be so much fun!

Remember, the markets are not where you live. If your investments keep you up at night, sell until you can sleep. Life is to be enjoyed, and I am doing my part. So have fun this week! And call some friends and share a few laughs.

Wishing he could be a bull analyst,

John Mauldin