Thursday, March 12, 2009

The Big Rally

The Lehmann Letter ©

The stock market enjoyed a huge rally this week. Have we bounced off true bottom and is the bear market over? Or is this just another bear rally that’s about to send us to new bottoms?

The S&P is now 750. If you update the chart below (blue line – left scale) with that figure, you’ll notice the S&P has fallen beneath the 2002 trough that followed the cot-com bust. Whether or not it rises from its current trough depends upon earnings per share and the P/E ratio.

S&P, P/E Ratio & Earnings Per Share

(Click on chart to enlarge)

Recessions shaded

If investor gloominess is an accurate omen, then earnings per share (red line – right scale) could also tumble close to its 2002 level. The underlying economy is doing terribly and getting worse, so investor’s pessimism may be justified.

And if investor sentiment is truly down in the dumps and the economy and earnings continue to do miserably, the P/E ratio (green line – right scale) will fall to levels not seen since the late 1970s.

Earnings of $40 per share and a P/E of 15 (the historical average) imply an S&P of 600 (40 X 15 = 600). Earnings of $50 per share and a P/E of 10 (as in the late 1970s) imply an S&P of 500. Those numbers are below today’s S&P closing and even below the S&P’s recent bottom.

So it all depends on the economy and earnings. Good news on banks and retail sales buoyed investor confidence and prompted this week’s rally. But if the economy’s fundamentals continue to erode, dragging earnings down further, this week’s rally may not set a trend.

Let’s hope this week’s good news is the real deal.

© 2009 Michael B. Lehmann

No comments: