We usually try not to depress our viewers over holidays, and before we forget-Have a Happy and Safe 4th of July weekend. However, we will try to make this short and make a few predictions for the rest of the year that may shock you. And then touch on the valuation quandary.
We believe the recession in the U.S. will be extremely severe and will spread to both developed countries and emerging countries alike. Denmark became the first Euro country to slip into a technical recession and a raft of weak data has indicated that others would soon follow. The euro zone is currently facing a combination of elevated inflation with tight credit conditions. But these concerns did not stop the European Central Bank from raising interest rates today to 4.25% from 4% to try to control the euro-zone inflation rate that just recently soared to 4% in June (this is twice the ECB's targeted inflation ceiling). Asia, and China specifically, have been growing at a very strong pace due to the insatiable appetite for the consumption of the goods they produce by U.S. consumers. A slowdown in the west would reduce the demand for their products and severely damage those econonmies.
Our prediction is that the second half of this year will produce a global recession. The catalyst for the global recession is the U.S. consumer hitting a wall due to their record debt, low savings rate, rising cost of food energy and health care, stagnant wages, and most of all, the wealth effect of the housing depression. We also predict that when the global recession becomes obvious to most observers, the destruction of demand will break the back of the commodity bull market including energy.
The valuation quandary continues to puzzle us. We just heard the head spokesman for S&P say that the market valuation is attractive at 15.3 times trailing earnings. Clearly, he was using operating earnings in making this prediction. We would like to refer you to the articles we've written about why it seems foolish to us to use operating earnings rather than the "reported" (GAAP) earnings. To refresh your memory on this, please refer to the latest Barron's article on the subject, "What is the Real P/E?", on our home page in "Comstock in the News" or the special report on the subject on the left side of the home page. In the special report we show you how to retrieve the earnings estimates of the S&P analysts by including this website http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS. As you can see, if you add up the earnings estimates for the trailing 12 months and divide that number into the present level of the S&P 500 you get a multiple of 17, not 15.3. And that is still using the estimate on the second quarter of 2008. Most analysts use the estimated "operating" (excluding write offs) earnings for 2008, or even 2009, to find a reasonable P/E. We do not think that is reasonable!! A perfect example of why not is shown in the table in the website above. In January of 2008 the analysts were predicting that total operating earnings for all of 2008 would be $98; in May they were predicting earnings of $92; and today they are predicting earnings of $88 for the year. Because of the constant fluctuations in the estimates, we have always argued that you should use the trialing 12 months or trendline earnings. Also, we argue that the GAAP "reported" earnings are the best metric for valuations. Using that metric we would be dividing the last 12 months of reported earnings ($57.66) into the S&P 500 (1263) and get a result of 22 times trailing earnings. This is a very high valuation level as most peaks in the market occurred at just over 20 times earnings (see NDR chart attached).
We recently heard a conference call by a well recognized institutional firm discuss why the market should trade at 1600 because that is a reasonable multiple of 16 times $100 of earnings. We called the firm to find out what we were missing in our thinking, and he came back with the fact that he is using forward operating earnings because that is the number all of "Wall Street" uses. Go figure!!