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Welcome to Another Lost Decade

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How to play this one a little smarter.

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A true, long-lasting bear market hasn't really taken place in the US, but has occurred across the pond in Japan, where stocks declined gradually, and not so gradually at times, falling more than 80% from the late 1980s until today.

If the US economy fails to stage a comeback with at least some nominal earnings growth over the next decade, what started as a range-bound market in 2000 will turn into a bear market, as high valuations are already in place.

Let's try to figure out the earnings power of the S&P 500. The current 2010 estimates of its operating earnings are $75, respectively. I'm skeptical of these numbers for several reasons:

First, they're almost double those of reported 2010 earnings estimates of $45. The percentage difference between reported and operating numbers is the second highest since 1988. (2008 holds the record. During the 2001-2003 recession the difference was about 50%). "One time" write-offs are responsible for the difference. It's very likely that these "one-time" charges aren't really "one-time;" thus operating estimates overstate the true earnings power of the market.

Second, 2010 estimates are only slightly below the all-time high earnings the S&P achieved in 2007, when our economy was under the influence of several bubbles, which at the time severely inflated corporate profit margins to unprecedented levels. Also, the bulk of excesses in margins came from the financial, materials, energy, and industrial sectors -- the ones that are struggling today and will continue to do so for a long time.

Finally, if earnings were to be as projected, we'd be following the last recession's recovery path, which is unlikely. The last recession was corporate, while the current one is riddled with debt-laden consumers. Deleveraging the excesses of the housing bubble, in the face of higher future taxation and likely higher interest rates (both byproducts of large deficits), will be a lengthy process. The recovery will be slower and real earnings growth will be lower than in previous recessions.

It's hard to know the exact earnings power of the S&P 500, but it likely lies somewhere in between operating and reported earnings estimates, and thus closer to $60, putting the P/E of the S&P 500 at about 19.

Since 1900, stocks have spent very little time at what is known as a "fairly valued" P/E of 15, spending less than 27% of the time between P/Es of 13 and 17 (two points above and below their "average" level). They only saw a P/E of 15 when they went from one extreme to another. Most importantly, they've never stopped at the average and gone the other direction; they've continued their journey to the other extreme.

During secular bull markets, investor optimism, bundled with constant reinforcement from rising prices, takes stocks to above-average valuations, causing P/Es to expand beyond their long-term average.

P/Es can shoot for the stars, but they don't get there: at the late stages of the secular bull market P/Es stop expanding. As earnings growth becomes the sole source of returns, disappointed investors start diversifying away from stocks into other asset classes (real estate, bonds, commodities, gold, etc.) -- and a range-bound market ensues. As the range-bound market marches on, un-met expectations reinforce disappointment in stocks, and P/Es are compressed to the other extreme.
No positions in stocks mentioned.

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