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Quarter-End Insights

Is More Upside in the Cards?

As bulls and bears debate whether 'it's different this time,' two big issues deserve more consideration.

It's been said that the four most dangerous words in investing are "it's different this time." Forecasting structural shifts in the economy or the stock market is certainly a low-odds endeavor, as "New Paradigm" pundits discovered in the late 1990s, and as economic Cassandras discovered earlier this year.

Sometimes, however, the world does move in a different direction than historical mean reversion would suggest. To pick a recent example, U.S. residential housing prices hadn't declined nationally since the Great Depression ... until they plummeted in 2008. It turned out that the housing market was different in 2007 than it had been during prior real estate bull markets, and those who recognized this fact made better investment decisions than those who did not.

I bring up this issue because one of the larger tugs-of-war going on in the investment community today is whether the most likely path for the market is muted returns--held back by a weak economic recovery--or robust returns, powered by an inventory-starved economy that will rebound faster than the skeptical consensus expects.

The latter camp notes that historically, there's a linear relationship between the depth of an economic downturn and the strength of the subsequent recovery. This camp also notes that lengthy periods of weak equity returns are generally followed by long stretches of equity outperformance, and that investor expectations remain fairly low. (Bill Miller's most recent quarterly commentary is a good example of this line of thinking.)

The less-bullish camp points to corporate profit margins that are still near cyclical peaks, leaving relatively little room for the operating leverage that can boost earnings growth during an economic recovery. They also point to debt levels that remain high across the American economy, which will constrain growth as consumers and businesses de-lever. The non-bulls (whom I hesitate to call bears, since that's an entirely different line of thinking), also point to a slow recovery in employment, which will naturally constrain consumer demand.

Are Things Really Different This Time?
Circling back to my opening point, note that this debate essentially hinges on whether things really are "different this time." The more-bullish arguments mainly rest on historical patterns that that are supposed to re-assert themselves, while the less-bullish ones posit a break from those patterns.

I don't find either set of arguments all that compelling. The bull argument--that history will repeat itself just because it always has--is weak on two fronts. First, extrapolating the experience of a dozen or so recessions into the current one would make any self-respecting statistician apoplectic, since the number of modern economic downturns is so small as to not even come close to being statistically significant.

Second, the economy and the stock market are what statisticians would call "non-stationary" data series. In other words, they change over time, and so relationships that were in place 60 years ago may or may not be valid today. Relative to even 30 or 40 years ago, our economy is more service-oriented, more levered, more closely linked to the global economy, and less unionized. The U.S. financial markets, meanwhile, are more liquid, less regulated, and populated with financial instruments that barely existed 40 year ago. So, I generally take any conclusions based upon historical patterns with a large boulder of salt.

The bear--or "new normal"--argument is somewhat more convincing, but it contains a few implicit assumptions that may or may not come to pass. First, the U.S. may deleverage slowly--or not at all--which would reduce this particular drag on profit growth. Second, a slow recovery in employment may not be as harmful to consumer spending as this camp expects. After all, unemployment for workers with a bachelor's degree or higher is just 5%, and well-educated workers have much higher incomes than less-educated individuals. Finally, demand has been so low for so long in the U.S. that the economy may generate above-consensus growth simply by satisfying deferred demand--cars wear out, households are formed, and so forth.

Globalization and Valuation
However, neither of these arguments really addresses the two big issues most on my mind at the moment. On the positive side, I'm thinking a lot about the effect of non-U.S. revenue on corporate earnings. On the negative side, valuations are not compelling.

Let's start with the globalization theme. Over the long haul, U.S. GDP growth and U.S. corporate profits have tracked each other fairly well, though with large cyclical swings. So, if future GDP growth is muted due to de-leveraging and weak job creation or weak income growth, it would seem logical for corporate profit growth to be weak as well.

However, there is a valid reason why U.S. corporate profits may grow meaningfully faster than U.S. GDP, which is the "D" in GDP. Large-cap corporate America is much less exposed to the domestic economy than one might think--in fact, around 40% of the S&P 500's net income comes from non-U.S. sources. Granted, a decent chunk of that is Europe, which is growing at the same speed or slower than the U.S., but a decent portion is emerging markets, which are growing much faster, and from a firmer economic foundation.

So, if prospective global ex-U.S. economic growth is higher than U.S. GDP growth, it's entirely possible that large-cap U.S. corporate profit growth could exceed U.S. GDP growth by a meaningful amount. Quantifying this effect is tough, but it seems to me a darned good reason why corporate profits may not be as constrained by the deleveraging U.S. consumer as some fear.

That's the good news. The bad news is the second big issue on my mind, which is valuation. Taking a step back, equity returns can be decomposed into dividends, earnings growth, and the change in valuations (earnings multiples). The yield on the S&P 500 is currently 2.1%, which is low by historical standards. Earnings growth has historically been about 6% nominal. Current earnings multiples are in line with mid-teens long-run averages based on consensus estimates for 2010, but are more stretched at about 19 based on the Shiller data, which uses an inflation-adjusted 10-year average.

Putting this together, it doesn't seem like a good idea to bank on the multiple-expansion tailwind that powered the last bull market starting in 1982--our starting point just isn't low enough right now. Yields are what they are, and while that 2% is nice to pocket, it's low on an absolute basis. So, we're largely left with corporate profit growth as the X factor that will have to power equity returns going forward.

I don't have any special insight into whether that figure will be meaningfully higher or lower than it has been over the past several decades, but I do know that I dislike putting all my eggs into one basket. I'd be a lot more comfortable if we had higher yields or lower valuations as insurance policies against a run of lower earnings growth. With luck, foreign income to U.S. companies will be the X factor that keeps equity returns moving up at a decent clip--but that's far from a slam dunk bet.

Before I wrap up, let me approach the earnings and valuation issues from another angle. The S&P 500 earned about $90 per share during its 2006-2007 peak. If we assume that the next peak will be somewhat lower, as the economy de-levers and adjusts to a "new normal," perhaps we get $75 to $80 in earnings. A 15x multiple on that earnings stream gets you to about 1100-1200 on the S&P, which is within shouting distance of current levels.

Now let's assume that the next peak is 10% higher than the last one. Why? Well, perhaps foreign income grows at a decent clip, and perhaps we get some operating leverage from the recent barrage of cost-cutting across corporate America. A 15x long-run multiple on $100 in earnings would be 1500 on the S&P 500--pretty meaningful upside from current levels.

The upshot from this scratchpad analysis is unfortunately the same: Substantial upside from here for the broad market seems to require that either the next peak in earnings is closer to the 2006-2007 peak, or that we get some sustainable multiple expansion. Both are certainly possible, but neither is what I would call a "fat pitch."

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