You Get What You Pay For

Another day, another rip higher in equities. Despite the dodgy leg, Macro Man is starting to harbour a desire to visit Pamplona this July. For someone with his relatively bearish disposition, that running of the bulls would appear to be considerably less dangerous than trading equities at the moment.

Fortunately for Macro Man, he by and large isn’t trading equities. But given the extraordinarily high cross-asset correlations, it feels like just about everything boils down to getting the S&P 500 right.

To be sure, the weight of money trumps all; indeed, this is how bubbles form. So while the fundamentals may or may not be rubbish, if there are lots of marginal buyers and no marginal sellers, the price will rise until equilibrium is restored. Trying to sell the top-tick is a game for suckers.

That having been said, it is worth checking one’s biases every so often. This is why Macro Man runs a medium term equity forecasting model that takes emotion out of the equation and attempts to provide an unbiased assessment of the factors that typically drive medium-term equity trends.

And in the latest run, the 12-month forecast has turned down again. This is partially a function of the recent rise in prices, but also an acknowledgement that earnings quality is pretty execrable, recent beats notwithstanding.

There is a lot of talk about how ‘cheap’ stocks are, but frankly, Macro Man just doesn’t see it. Oh sure, it you look at operating earnings- particularly the operating earnings expected from bottom-up analysts- you can convince yourself that equities don’t look too pricey. But this ignores the record divergence between operating and reported earnings, the latter of which contains the “one off”, “extraordinary” write-downs (that seem to occur with quarterly regularity) known affectionately in this space as “turds.”

It is frankly ridiculous to look at earnings with the turds stripped out, not least because the continued presence of the turds is what has put the monetary framework in place that allows banks, etc to “earn” their way back to health.

And while there’s no guarantee that equity analysts of any stripe are going to be right, Macro Man places a great deal more faith in the top-down folks (who forecast both operating and reported earnings) than the collective wisdom of the bottoms-up crowd, all of whom seem to live in Lake Wobegon.

Looking ahead to the end of next year, at current pricing the SPX is looking like a 20-25 P/E on 2010 earnings. That puts the earnings yield roughly in line with 30-year Treasuries, and well below yields offered bv investment grade credit.

Those markets appear to offer superior investment opportunities at current pricing. Macro Man understands the importance of money flow in driving short-term price action, which is why (despite his frequent bearish mutterings), he has largely refrained from trying to strap on the bear trade.

But those managers and allocators who are throwing in the towel and buying stocks should remember: at the end of the day, you get what you pay for.

Graph 1: S&P

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