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Why Stocks Will Stop Defying Valuation Gravity


The belief that new highs can be reached is anchored by a myth.

Romantics have a word that best describes the stock market's current levitation act: nostalgia. The newly emboldened buy-the-dips crowd, flush with cash and longing for the bygone days of beta-inspired rates of return, perceived the recent market swoon as yet another opportunity to defy valuation gravity and are apparently attempting to levitate stocks to new highs. Will it work? I doubt it. For anchoring this enthusiasm is a valuation myth that has a high probability of evaporating, come this fall.

What I'm referring to is bottom-line problem to top-line growth.

Revenues are a product of price times units sold. The growth of each results in sales growth that drives strong bottom-line numbers once an economic recovery gets underway, which is where the global economy stands today. There's only one problem with this myth, I mean math: Price increases are virtually non-existent in most industries, which leaves units sold as the primary (if not sole) area of revenue growth. As the data and going-forward guidance from second-quarter 2009 earnings reports make abundantly clear, units sold aren't producing -- nor are they expected to produce -- robust (as in double-digit) growth numbers any time soon.

The valuation math is this: an appropriate P/E times reasonable earnings expectations minus an appropriate discount rate equals fair value. As I've noted on numerous occasions, that works out to be the following:

15 times $70 = 1050 minus 10% = 945 fair value.

However, let's consider the risk to this scenario. What if that $70 S&P 500 operating number for the next 12 months (mid 2010) comes in below $70 -- let's say $65. Then the valuation math works out this way:

15 times $65 = 975 minus 10% = 877 fair value.

Let's take a moment to look at each facet of the fair-value inputs.

The levitation bulls would say that low inflation justifies a higher P/E. But is a higher P/E appropriate when the global economy and financial system are still in repair? Moreover, is deflation (which would destroy valuation levels) definitely off the table? I say no to both.

As for operating earnings, to get to the $70 number, bottom line must equal or exceed double digit rates. There's absolutely no guarantee that this will occur in light of the aforementioned risks to top-line growth.

Moreover, I've had an excellent experience with my Macro Economic Reports Indicator (MERI), which tracks consensus expectations for major economic reports and then applies those expectations to earnings results. In the recent second-quarter 2009 earnings season, MERI scored a home run, predicting above-consensus results. However, as the accompanying table makes quite clear, the net number has stagnated since peaking on July 10, strongly suggesting that above-consensus earnings expectations are unlikely.

Without above-consensus earnings results, getting to a $70 number is difficult at best. Should this thinking start to permeate the markets, stocks should adjust -- to the downside.

Finally, as it is, the discount rate of 10% is generous. The historical discount rate for large-cap stocks is 12%. A smaller discount rate would grossly inappropriate.

Investment Strategy Implications

On Tuesday, I described some of the challenges that a sustainable economic recovery faces as the global consumer limits his/her spending appetite. I referenced the role China will play in this regard. The fact that the levitation bulls chose to ignore the risks that the Chinese economy faces (by spending all of their stimulus money in an area of limited sustainable use) and slipped right back into their buy-the-dips mode is an outstanding example of nostalgic thinking.
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No positions in stocks mentioned.
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