Monday, November 12, 2007

Be Your Own Economist ®

The Lehmann Letter ©

November 12, 2007

Dear reader,

The stock market opened higher this morning despite Friday’s dizzying drop just before the market’s close. Perhaps last week’s downward spiral was a temporary stumble on the road to ever-higher numbers.

After all, Federal Reserve Chairman Ben Bernanke recently forecast continued economic growth. Mr. Bernanke said the economy is resilient and, despite an anticipated soft patch in the near future, should maintain positive numbers.

We’ll see.

Meanwhile, Chart 2-1 from the Be Your Own Economist ® web site, (click on Seminars and then Charts), shows that the S&P 500 (blue line) has regained its 2000 peak. Key question = Can it permanently break through to new and higher ground? That depends on earnings, which depend on the economy. There’s no way the stock market can keep going north if earnings head south, and there’s no way earnings can levitate higher if the economy slumps.

The chart’s red line, EPS for earnings per share, pulled the stock market upward in the early 1990s, and then something strange happened. The blue line (S&P 500) began to climb more quickly than earnings per share (red line) as speculators bid stock prices upward ahead of earnings growth. The great bubble had begun. Investors bet that future earnings growth – generated by the New Economy – would justify higher stock-market numbers.

It didn’t come out the way they planned. All bubbles pop or deflate, and so did this one. Stocks followed earnings down hill until strong recovery began in 2003. This time investors were far more cautious and let earnings take the lead. Now earnings are much higher than they were at the turn of the century but, as I said earlier, stock prices have only just recovered their earlier peak. Investors are no longer willing to bet on the future. They need results now.

Earnings must maintain their upward trajectory for the stock market to continue climbing. But how can earnings grow if the economy stalls or, worse yet, dips? That’s why all eyes are on the economy and the bad omens are making investors nervous.

Yours truly,

Mike Lehmann

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