PORTFOLIO POINT: The prospect of profits falling in 2008-09, rather than rising at a slower rate, could lead to a further 40% fall in the market.
What follows is not a definite prediction, but a scenario. In times like this predictions are more or less worthless, so we are left to examine scenarios.
There are too many unknowns and too much distance between variables to base your investment strategy on “pick-a-prediction”.
One scenario – the least bad one but also the least likely, in my view – is that the world’s central banks engineer a mild recession (continued growth is out of question) and the market only falls another 10%, perhaps after a pre-Christmas rally, before bottoming ahead of the economy and steadily recovering over the following years.
Another one, and also unlikely in my view, is for deflation and Depression (10% GDP contraction) leading to a decade of economic and investment misery.
There’s another scenario that is somewhere between the two economically but still produces a further 40% leg down in the sharemarket, based purely on arithmetic. With apologies to Raymond Chandler, it might be called The Long Goodbye (to the long bull market).
I’m describing it not because I am certain it will happen, but because you need to be aware of how and why it might.
And by the way, this has little do with whether Barack Obama and Kevin Rudd can prevent hard landings in the US and Australia (I don’t think they can). It’s about market maths and investor psychology, as well as the reality of next year’s profits.
Here’s how the arithmetic works. If a company is earning $1 a share and its price/earnings multiple (P/E) is 25 times, then its share price is $25. If the P/E is 10 times and earnings fall by 25% to 75¢ a share, then the share price is $7.50 – 70% lower.
The prospective P/E of the Australian market is currently about 11 times, but the consensus analyst forecast is still for a 10% increase in earnings in 2009.
The 40% decline in the overall market so far is due to a shrinking of the market P/E from 17 times to 11 times, and a pullback in analysts’ earnings forecasts for 2009 from about 20% growth to 10%.
(If this year’s earnings per share is $1, then 17 times $1.20 – next year’s earnings per share, or EPS, assuming 20% growth, equals a share price of $20. If profit growth is 10% instead, next year’s EPS is $1.10. Eleven times that is $12. A fall from $20 to $12 is 40%, which is what has occurred).
But what if profit forecasts move to assuming a fall in 2009 by 20% instead of a rise of 10%? And what if the market P/E comes back to 9 times, rather than 11? That means a forward EPS of 80¢, down from $1 in 2008. Nine times that is $7.20 – down 40% from the current price.
That’s how a prospective profit decline of 20% and a notch down in the market P/E from 11 to 9 would produce another fall of 40% from here, and a total fall from last November’s peak of 64%.
Will profits fall 20% next year? Will analysts and fund managers begin to factor that in after the interim profit reporting season in March? I don’t know, but quite possibly. It is certainly more likely than a 10% average profit increase.
In some ways, the matter of 2010 forecast earnings is just as important for next year’s share prices. These will unfold over the first half of next year, based partly on the interim profits but also on what happens in the economy and cost reduction announcements by the companies.
I think it is plain that profits will fall over the next two years, not rise. The fact that consensus earnings estimates still see a 10% increase simply means the analysts have not been able to adjust their models quickly enough as the facts have changed.
And what is the right P/E for the market over the next few years? Is it 11 or 10 or 9, or will it quickly snap back to the long-term mean of about 15 times?
Although it’s true the long-term average is about 15 times, which means that shares look historically cheap right now on a market P/E of 11, there have been uncomfortably long periods in history when it was below 10 – 1910–1920, the 1930s, most of the 1940s and 1950s, and the period between 1975 and 1982. Of course there have also been periods when it was above 20: most of these were during the debt-fuelled boom of the past 25 years.
As Lord Keynes once said: “The market can remain irrational for longer than you can remain solvent.”
I don’t know what is going to happen to the market from here, although I was attracted to the proposition put last week by my friend and fellow Eureka Report shareholder, Mark Carnegie in his feature on Warren Buffett (see In defence of the king).
He asked why, when we have a “once in a lifetime 40%-off sale”, the media is obsessed with whether the market will come down another 10%.
Another 10% is neither here nor there. What I am worried about is the smaller but genuine chance of another 40%.
There’s another thing that Keynes said, when criticised on changing his position on monetary policy during the Great Depression, that is worth repeating: “When the facts change, I change my mind. What do you do, sir?”
A few things changed last week - some for the better, some for the worse.
Americans voted for an interesting new President, the Monetary Policy Committee of the Bank of England voted for a 1.5% rate cut, the US car industry took a big step closer to total collapse, and two of Australia’s wobbling companies, Allco and ABC Learning, toppled over.
That’s two-all: two positive changes, two negative.
Along with a few other commentators, I’ve been suggesting that the sharemarkets looked ready for a strong rally into Christmas after a horrible October, which would provide a “get out of jail” pass for you to reduce gearing and further unload more portfolio dogs.
That was partly based on a belief that Barack Obama would win the presidential election amid scenes of jubilation (which happened); and that the world’s central banks and governments would continued to slash interest rates to soften the landing and hold back the rise in unemployment (which is also happening).
Price/earnings multiples look low and yields look high; with a bit of positive news on interest rates and more optimism in the United States, there seemed no reason shares would not go for a run.
The trouble is that the ground beneath the markets is now shifting very quickly. Spending is slowing very quickly and companies are responding virtually in a panic with drastic cost reductions.
Every chief executive I speak to these days is cutting staff; he or she can see that a recession is coming and that sales are falling, so they are getting in early to beat the rush, which of course ensures that unemployment rises and that the feared recession does, indeed, happen.
Companies that have been just hanging on, Allco and ABC, are now falling over. Others, like Centro, will probably go soon as well, and dozens of banks in the US are expected to collapse in the month ahead.
This raises the likelihood that banks will cut dividends next year as bad debt provisions rise, which would be devastating for a market that has been grounded on bank dividends for 15 years.
Just as the wealth-creation process during a boom creates its own momentum through the virtuous cycle of rising property and share values, rising confidence and rising borrowing and spending, which feeds into still higher asset values, the reverse happens in a bust … and the sharemarket gets its most meaningful expression in the shrinkage of both profits and P/E ratios at the same time, reversing the leveraged effect of expanding profits and ratios during the boom.