Commentary: A silver lining in the cloud of recession

-- Elvis Picardo is a strategist and analyst with Global Securities in Vancouver, Canada. The opinions expressed are his own. --

VANCOUVER ( -- As 2008 draws to a close, it seems none too surprising that this year of trillion-dollar losses and gut-wrenching volatility should end with the unearthing of a fraud of epic proportions, the $50-billion Madoff “Ponzi scheme.”

How bad has 2008 been? Let us count the ways. $28 trillion lost in global market capitalization; $2.8 trillion in U.S. household net worth wiped out in the third quarter alone; more than $1 trillion in losses and writedowns taken by financial institutions (mainly U.S. and European) on mortgage assets. The toll in other areas is equally staggering. Close to 2 million jobs have been lost in the United States this year, and mortgage delinquencies and foreclosures are at record highs.

Earlier this month, the National Bureau of Economic Research (NBER) confirmed what was becoming increasingly evident by the day - that the United States is already in the throes of a recession. While that is certainly not good news, this particular cloud may have a silver lining.

The silver lining lies in the fact that this recession has been under way for more than a year now, according to the NBER. Over the past 150 years, the average U.S. recession has lasted for 17 months. As well, over the last 100 years, the average U.S. bear market has lasted for about 13 months and resulted in a 30 percent decline, according to the Stock Trader’s Almanac.

The scale of the current economic crisis indicates that this recession may be the longest in the post-World War II period. It certainly seems to be on track to exceed the 16-month economic contractions that ended in 1975 and 1982, which were the longest in the postwar period.

However, equity markets are already discounting a severe recession, given that the S&P 500 and Nasdaq Composite have plunged about 40 percent so far this year. While equity markets may see further weakness in 2009, it seems as though much of the damage has already been done.

If 2008 proved one point, it was that the United States still remains the economic engine of the world, as optimism that the rest of the world could “decouple” from the U.S. economy and continue to grow proved to be totally unfounded. In fact, Europe and Japan also entered into a recession sometime in the second quarter, making it the first simultaneous contraction in the three regions in the post-WWII period.


Two factors may help to dispel the global gloom, as relative calm follows the financial storm. Firstly, the massive and timely fiscal and monetary stimulus by central banks around the world, spearheaded by the Federal Reserve, may help to stabilize global markets and eventually restore the confidence of investors, consumers and businesses.

Secondly, the risk pendulum has swung so far - from extreme complacency before August 2007 to an extreme level of risk aversion at present - that some level of normalcy is to be expected in 2009; this can only be positive for the markets. My Financial Armageddon Indicator (FAIL®), which measures concern about a systemic collapse of the global financial system, is trending firmly lower after peaking in October at levels not seen since the crash of 1987.

How did analysts’ earnings estimates for U.S. companies fare in 2008? After being too bullish in the first half of 2008, consensus estimates have come down sharply as company after company reported dismal numbers in recent quarters. Based on “bottom-up” estimates compiled by Standard & Poor’s, operating EPS for the S&P 500 was expected at $96.79 in April. That forecast has since been slashed by over 30 percent to $66.22 at present, which would represent a 20 percent decline from last year’s EPS of $82.54.

2009 index earnings for the S&P 500 are forecast to increase 26 percent to $83.44. Current earnings estimates indicate that analysts are pinning their hopes on a strong recovery in corporate profits in the second half of 2009, with earnings forecast to rise 37 percent from the depressed levels of 2008.

The EPS forecast of $83.44 implies that the S&P 500 is trading at a forward earnings multiple of 10.6, which makes it appear inexpensive. The index also appears undervalued by another measure - comparing its dividend yield to the yield on the US 10-year Treasury bond. The S&P 500’s dividend yield of 3.23 percent exceeds the 2.08 percent yield of US 10-year Treasuries by 115 basis points, the biggest gap in decades.

The earnings turnaround next year is expected to be led by banks and financial institutions, as their profits are forecast to rebound after a disastrous 2008, with significant earnings growth also expected in the consumer staples and discretionary sectors.

Two sectors that appear attractive on the basis of long-term fundamentals are Energy and Health Care. The Energy sector has endured a steep selloff as crude oil prices have plunged 75 percent from their peak in July, with the result that the sector now trades at a forward multiple of 8.3 times forecast 2009 EPS. Although energy prices can be expected to remain volatile in the short term, imbalances in global energy supply and demand should resurface as economic growth resumes, supporting higher prices.

Health Care valuations have also compressed sharply over the past year, with the sector trading at a forward earnings multiple of 10.2, compared with a P/E of 17.6 in 2007 and 19.3 in 2006. While the sector remains depressed by concerns about generic competition and regulatory risk, it should find support from its stable cash flows and healthy dividend yields, not to mention demographic trends.

Earnings for the S&P 500 index plummeted 26 percent in the first quarter of 2008 and 29 percent in the second quarter. With almost all of the index constituents having reported, third quarter earnings are expected to decline 24 percent, and actually increase 9 percent in the fourth quarter of this year. If the second quarter did represent the trough in earnings for the S&P 500, 2009 is likely to be a year of modest upside for the index. If not, fasten your seat belts, because more turbulence may be in store.