Overview

Equity markets are currently a wild roller coaster ride. With volatility remaining high, most days bring gut wrenching up and downs. No-one knows what is going to happen tomorrow or even next year, though that’s the one question that keeps being asked. I never was a boy scout, but I am a big believer in their motto of being prepared.

Many market participants suffer from the need to do something, to buy or sell. They may achieve better results if they stopped doing and started planning. One way to beat an index is timing one wave correctly. As the equity markets are like an ocean there is never a shortage of new waves to get in tune with. Rather than guessing when to start paddling to ride the wave, get in tune with the waves then watch and react at the right times.

That’s enough of the nebulous phrases, let’s dive in to see how to put it in to practice.

Looking ahead

If you have some idea of which way the roller coaster is likely to head the ride is more enjoyable and less gut wrenching. Looking at the S&P 500 from historical and expected perspectives is one way of forming an opinion on the overall direction. S&P 500 Q3 2008 earnings are now 98% reported. The following chart shows reported and operating earnings for 2000-2009. Q4 08 onwards are the S&P estimates and I added the percent difference between operating and reported earnings. If you want to know the what is the difference between reported and operating then have a look through the selected readings at the bottom. In summary operating earnings back out write-downs and other non-operating costs, but as such are open to manipulation by companies.

Thomas Nogales in his December newsletter suggested reported earnings where the only true measure of profitability (my interpretation of his words). [Note: Nogales bought S&P at 816 on Dec 1st] I agree reported earnings are of prime importance, but I see value in both sets and in the difference between them. As this chart shows the difference between reported and operating costs during good times is low, while during tough economic times the difference blows out. The primary reason for this is the amount of non-operating write downs are considerably greater during tough time. So while the the average difference from 1988-2007 was 16% and 10% during the good times, it is now 42% and projected to hit a whopping 75% by end of 2009. Consider the following:

• The quarterly low for both reported and operating earnings occurred in Q4 2007
• The TTM low for operating earnings is expected to be the just completed Q3 2008
• The TTM low for reported earnings is expected to be Q2 2009.
• Economists are now saying the US recession started at the end of 2007. The average recession from 1948-1991 is around 11 months, the average of the six sharp recessions form 1923 on is 12.5 years with the longest at 16 months. So as the chart shows this recession and earnings are likely to improve this quarter or soon there after.
• Although the daily moves on the equity markets may feel like a roller coaster, a slightly longer perspective reveals that markets move in waves.

My speculation is that at times like this it pays to keep a close eye on operating earnings as they are giving a clearer picture.

Three Charts and a Table

So we now know that earnings improvements are likely to be close at hand. What should we be looking at buying now. There are four sectors which stand out as good places to look. I’ve give you a clue, energy is not one of them

As the table shows consumer discretionary, financials, health care and telecommunication services are worth diving into for a look. Drilling down on consumer discretionary shows that earnings are projected to finally head north in Q2 2009. Look at the year on year quarterly rate of change for Qs 2-4 and consider whether you want part of that action. Does this fit in with what we know. The recession is  scheduled to end late this year or early next. Consumers have been curtailing spending, while those with jobs have and will in general benefit from increased cash flow due to reduced mortgage costs and oil prices. Retailers have been doing it hard and their share prices refelct this. Pent up demand is set to explode once people see the other side of this recession and retailers will be a large beneficary. I’m currently looking at a number of names in the retail space.

A sector even more beaten down is Financials. The following chart shows how dramatic the fall and eventual recovery will be. It’s no wonder we’re seeing 10% plus swings on big financial names and over 20% swings on the smaller names. I continue to look at companies in the financial sector.

Finally a graph of S&P 500 dividends from 1988 to present. I probably should have converted this to log scale to make the trend clearer. However, you can see that dividend growth has risen sharply during the recent peak earnings period. This growth is not sustainable and dividends are being cut at the fastest rate since 1958. Regardless of the cuts this is the first time in 50 years that the dividend yield on S&P is higher than 10 year treasuries. Read this thread at TMF for more on S&P dividends.

While it is still too early to be using margin I am comfortable with my current close to 100% cash allocation in equities. If the markets take off I’m aboard and if they fall further I have my non-callable “margin” waiting ready to invest.

Previous Thoughts on the S&P 500 at FI

http://www.fusioninvesting.com/blog/2008/10/how-low-could-sp500-go/

http://www.fusioninvesting.com/blog/2008/10/sp-500-earnings/

Reported vs Operating Earnings and Other Selected Reading

• http://www.bullbeartrader.com/2008/05/pe-ratios-using-reported-and-operating.html
• http://www.decisionpoint.com/TAC/SWENLIN.html
• http://www.contraryinvestor.com/mo.htm
• http://www.hussman.net/wmc/wmc081201.htm
• http://papers.ssrn.com/sol3/papers.cfm?abstract_id=319320

Related posts:

1. Thomas Nogales November Letter – Hussman plus S&P500
2. S&P 500 Operating Earnings – What Are You Focusing On?
3. S&P 500 Sector Earnings