Guest Post: "So Much For The Market Being Cheap" Charting A 50-75% Downside Case In The S&P

Submitted by Brandon Ferro, Managing Member of Hevea Partners

Some Market Thoughts worth Sharing

Historical market data that suggest our current situation resembles very scary periods in times past (i.e., the 1929 crash to be specific) is beginning to pile up.

Let's look at the set up from the perspective of charts.

Here are historical bear markets, indexed to 100% (100% = bull market peak). 

It's quite easy to see that the current bear market that began in late April has been more ferocious than the average bear market through history at this juncture of its development.

In fact, this bear market looks an awful lot like the way the 1929 crash shaped up.  While other individual bear markets have fallen faster and by a greater amount, they were all short-term crashes, such as the 1987 crash and the 1998 Asian Financial crisis crash. 

As such, they ended very quickly.  The current one, however, seems to be more drawn out, again looking very similar to the 1929 crash represented by the red line.

What is worth noting is that despite the fact that we witnessed a mini-crash in May and a $1T support package for Europe thereafter, the current tape action is still as weak as it is and is leading to the set up in these charts I'm discussing. 

Despite the latter events, one of which was supposed to be cathartic to an over-bought market and the other supportive to global economic stability, we're still hanging on the edge of a cliff it seems.

Now, let's specifically compare the 1929-1942 bear market, which began with the 1929 crash and largely ended with US engagement in WW2, to the 2000-2010 period, which has seen two massive bear markets with two major rallies of 100% and 85% in between. 

It is amazing how closely these charts resemble themselves in terms of price action and the timing of each cycle’s respective moves.  It seems to me that the only major difference is the order in which events seem to be playing out. 

For instance, they had their crash quickly while we have avoided ours for 10 years with profligate monetary policy and government spending. 

It seems to me that the market is now recognizing that the game is up; no amount of additional money, bailouts or otherwise can prevent the system from collapsing under the weight of all the debt that has been allowed to build.  That's why it seems as if the far end of the black line is on the cusp of doing what the red line did on the left side of this chart in 1929.

Again, the same events, just reversed - politicians unwittingly took austerity measures in 1929-1930 that caused a depression and they're doing the same thing now, just 10 years later than expected.

If you look at the dotted black line, it represents the absolute low of the 1929-1932 depression, a roughly 85% decline in all on a monthly basis.  For context, this correlates to roughly 230 on the S&P500.

Question is, their bear market ended when we entered WW2; is Iran and Israel the catalyst for a similar situation in 2012 when this analytical work suggests our bear market could end?  They could theoretically pull the world into their mess given the resources at stake and the emergence of a resource rich country in China.

Which brings me to the S&P500 / Gold ratio chart. 

Historically, the value of the S&P500 relative to the price of gold reaches a bottom at roughly 28% (all-time low = 19%).  The ratio is currently 94%. 

Assuming a gold price of $1,500 or $2,000 (reasonable given fundamental backdrop) suggests an S&P500 value of 375-500.

Isn't it crazy to see how the market cycles vs. the price of gold through history?  This is the third major secular bear market for stocks relative to gold over the past 110 years and it shows up decisively in the chart. 

If you believe that everything reverts back to its mean and even overshoots (i.e., when you stretch the rubber band too hard in one direction it has to snap back even harder in the other), then the unprecedented explosion in the market vs. the value of gold in 2000 (almost 6.0 on the chart) relative to other historical peaks at the top of secular bull markets (1929 and 1966) suggests greater upside than $1,500-$2,000 for gold and more downside than 375-500 for the S&P500.

Further, the SPX / Gold ratio chart is where we form our timing thesis of 2012 being a potential bottom for this secular bear. 

Notice how troughs in the S&P500 relative to the price of gold have typically taken 12-13 years to play out.  The S&P500 put its peak in relative to gold 10 long years ago in 2000.  We sure are close.

Let's also look at the valuation on the market (Price-to-Earnings ratio or P/E) when it has typically reached major, major bottoms which have led to new periods of prosperity and huge, secular bull markets.

Typically, the P/E on the S&P500 has reached b/t 6x-8x earnings per share (rolling Shiller 10 year average), well below the current ~19x. 

Notice how the “generational low” in February 2009 (dark black), which preceded the 85% rally over the past year, was probably not the generational low everybody thought it was - the P/E on the market never went below 14x.  Also note the P/E at the 2003 lows (white).

If we assume $70 in S&P500 earnings per share in 2011 (mild recession in 2H10 and 2011) and use a 6x multiple you get an S&P500 value of 420. 

To really nail the overall thesis for you here is a comparison of the P/E ratio on the market during major, long-lasting, secular bear markets.

I’ve indexed the P/E to 100%, the point at which it peaks during the end of a secular bull market.  As the lines move right and lower it represents the amount by which the S&P500’s 10 year P/E has contracted relative to its peak in the past secular bull move.

The black line represents the bear market we've been in since 2000.  The marker represents today's data point. 

As it stands, P/E ratios have contracted by roughly 50% from their level in 2000 (45x, vs. only 35x at the peak in 1929).

Notice how much further valuations have to contract to reach the level of contraction they have reached in other secular bear markets. 

The chart indicates valuations bottom when they have declined about 80%-90% from their high.  Using the 2000 P/E of 45x this yields ~5x-9x, in-line with my chart above which says market bottoms are reached at P/Es in that range.

Let’s play devil’s advocate and assume that S&P500 earnings estimate of $95 (LOL) in 2011 is correct…

Even if it happens, this chart suggests it could be more than offset by material P/E contraction that has yet to take place.  A 6x-8x P/E on that $95 number next year would yield 570-760 on the S&P500, well below the current 1,030.

Therefore, even if you want to make the bull case for earnings, the latter chart suggests you’ve only figured out half the story; you also have to make an entirely unlikely bet that the black line will diverge and we will start to witness massive P/E expansion unlike any we have ever seen before at this stage of a secular bear market.

I’m not saying it’s impossible, but it sure does seem implausible given the way history looks in the chart hah?

So much for the market being cheap.