The Stock Market Is in Uncharted Territory

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Right now, it's the slowdown in the rate of economic decline that matters. As long as the economic data validates the "green shoots" scenario, and things keep getting less bad, it seems that the market will keep rallying as investors assume -- understandably so -- that the economy will start growing.

This may be why the U.S. dollar has been selling off of late -- as its safe-haven status is no longer in high demand. In an opaque way, the dollar's weakness is a sign of economic stabilization, so it's up to the second derivative of economic growth to determine the value of the U.S. currency and stock market.

The May numbers
Fools may know by now that I like to look at monthly S&P 500 sector performance to put the past month's events in better perspective. The optimism that commenced in March and carried into April also continued last month. Let's dig into the performance results:


May 2009

April 2009

1st Quarter 2009

2009 YTD


S&P 500
























Consumer Discretionary






Consumer Staples






Health Care












Information Technology


















Source: Standard & Poor's.

Financials and energy were the only double-digit advancers as the pace of the rally slowed down in May. Energy finally began to rally, gaining better than 10% for the month; it was the second-best sector after the notorious financials, which appreciated another 13% in May. In the energy space, I like ConocoPhillips (NYSE: COP  ) as a more leveraged play on the price of oil and ExxonMobil (NYSE: XOM  ) as the most defensive energy stock, due to its huge cash position and recent exciting oil finds.

That the market was led by the group that is to blame for the black hole we sunk into in 2008 -- financials -- is a worrisome sign. The experts that had been right all along on the sector say this is a bear market rally. In my experience, bear market rallies are usually the sharpest and most spectacular in nature, so standing in front of a moving train is not advocated -- financials (the moving train) are up 38% since the beginning of the second quarter.

I remain steadfast in my belief that investors should only stick with well-capitalized banks. Those that have been approved to return TARP funds -- particularly Goldman Sachs (NYSE: GS  ) , JPMorgan Chase (NYSE: JPM  ) , and Morgan Stanley (NYSE: MS  ) -- are a good place to start looking. Though these names have not rallied as much as the low-quality stocks in the financial space -- like Citigroup (NYSE: C  ) , which was just booted off the Dow -- they will not decline as much in a correction. You're always better off with well-run companies.

Time to buy utilities?
Utilities are down the most thus far in 2009, and if this rally is for real -- more in a second on why that's a big if -- they should catch up with the rest of the market. Utilities are economically sensitive and will perk up if the economy improves. Also, a rise in Treasury yields usually is a headwind for the sector, but I believe that bond yields are unlikely to go much higher in the short term.

There is one utility company that has a distinct competitive advantage -- Exelon (NYSE: EXC  ) -- as it owns the biggest nuclear power generating capacity in the United States (third largest in the world). I'm a big believer in buying good stocks when they are down. This one was cut by more than half at the March lows, but the nuclear reactors are still there.

Those dreadful generally accepted accounting principles
We went from too much pessimism at the lows in March -- near 666 on the S&P 500 -- to too much optimism, with the market tagging 930 in early May. In the process, the S&P 500 managed to trade above 131 times trailing GAAP earnings.

On the issue of GAAP P/Es, I was asked the following by one of our editors: "Just a devil's advocate question: Isn't it easy to justify the 131 P/E by saying it's artificially low due to one-time write offs and other adjustments that will likely disappear in the future?"

I tracked down the GAAP earnings estimates for the June quarter for the S&P 500 -- a whopping $6.17. Now, the S&P 500 companies earned, according to those dreadful generally accepted accounting principles, $7.57 in the March quarter (with 97% of the data calculated as of the time of this writing). In the fourth quarter of 2008 they lost an astounding $23.25; in the prior two quarters they earned $9.73 and $12.86.

Before we proceed, here is a historical table of the S&P 500 GAAP earnings and P/E ratios, supplemented with future estimates.

Quarter Ended

S&P 500



December 31, 2010




September 30, 2010




June 30, 2010




March 30, 2010




December 31, 2009




 September 30, 2009




June 30, 2009




March 31, 2009 (97%)




December 31, 2008




September 30, 2008




June 30, 2008




March 31, 2008




December 31, 2007




September 30, 2007




June 30, 2007




March 31, 2007




December 31, 2006




Source: S&P, author assumptions.

I lack the clairvoyance to know where the market will close on June 30, 2009, but I will assume that it will be flat and close where it did in May -- at 919.14. If we do make that $6.17 quarterly EPS that the top-down estimates are calling for, the S&P 500 will trade at a GAAP P/E of 4,259. That's not a typo -- we lose the $12.86 we earned in the last June quarter and instead add the $6.17 from the current June quarter.

Let's assume the market sees through those write-offs and rallies to 1,500 by the end of 2010, appreciating by 100 points per quarter (yes, I know this is generous). But the EPS assumptions that come from top-down estimates collected by Standard & Poor's do not seem to see through those one-time write offs. The GAAP P/Es in the table above speak for themselves. Even if the market stays flat by 2010, the S&P 500 GAAP P/E will remain in the 20s -- according to S&P's top-down consensus estimates for EPS, not mine -- which is expensive by historical standards.

Also, the S&P 500 is on target to trade with negative trailing-12-month earnings by September -- and that is a big event. Any way you slice it, we are in uncharted territory. The optimists cannot be sure that the rally will continue under these conditions, nor can the pessimists (including this one) be sure when it will fail.

More macro-market Foolishness:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 09, 2009, at 2:00 PM, bigpeach wrote:

    Ivan, I really wish you would would stop writing about index P/Es. We've discussed at length on this site why that can be so misleading as a valuation metric. Writing things like this does little but unecessarily scare investors.

  • Report this Comment On June 09, 2009, at 3:22 PM, observer001 wrote:

    What is a company worth to an investor? It's worth the net present value of its future earnings. Price always depends on earnings. P/E is therefore always relevant, even though there may be different views on how to measure it or what it "should" be.

    Thank you for the thought-provoking table, Ivan.

  • Report this Comment On June 09, 2009, at 3:29 PM, ivanmartchev wrote:

    All I did is present the facts; they are what they are (those are S&P's GAAP EPS estimates, not mine). As Bernard Baruch said long time ago: “Every man has a right to be wrong in his opinions. But no man has a right to be wrong in his facts.”

    Just the facts, ma'am.

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