capping the upside

The main conclusion Wall Street seems to be taking from the May jobs report and yesterday’s Bernanke speech (growth is slowing, no new stimulus measures) is, I think, the correct one–that, as investors, we can no longer imagine an unlimited upside to the US economy.  We’re probably not going to be putting 1-2 million now-idle workers back on the job in the coming twelve months.  So the economy won’t be benefiting from a surge in pent-up demand as these extra paychecks are spent.

The reality is that the top 20% of the country by income does the majority of consumer spending, and that another .7% added to the workforce won’t change the GDP numbers in any noticeable way.  It’s the dream that next year’s eps will be at least up x% that’s fading.

looking at the numbers

As I mentioned yesterday, the earnings of the S&P 500 are composed roughly of 50% domestic profits, 25% from the EU and 25% from emerging economies.  If we were to say that US and EU profits will be up by 5% each next year and those from emerging markets will gain 20%, the result is that aggregate S&P earnings would likely rise to $110 from the $100 I’m penciling in for 2011.

If we apply a 13x multiple to these earnings, that would imply that the S&P could be trading at 1430 twelve months from now.  That, in turn, would suggest that at, say, 1250 the S&P is a compelling alternative to other publicly traded asset classes.

imponderables (two of them)

1.  is a 13x multiple the right one?  My guess is that it’s a bit too low.  The counterargument is that the US has lost the special place in the world that it has held since World War II as the economic and political leader of the globe (see Jeffrey Sachs’ op-ed about the IMF in the Financial Times on May 31–“A manifesto for the fund’s new supremo” for an example of what many people, especially outside the US, are thinking).

A slow domestic economy suggests interest rates are going to remain lower than Wall Street has thought, and for longer than expected.  This should imply a higher than usual pe multiple for the stock market.  But the idea that the US is politically adrift and lost in dreams of past glory argues in the opposite direction.

Who knows which factor will dominate?  For lack of any better insight, the consensus may well call them a wash.

2.  can the stock market be strong if the economy isn’t?   We have (at least) two relatively recent examples that address this question:

–Japan post-1989.  During the subsequent “lost decade” in Japan, export-oriented industrial companies went from strength to strength in profit terms while domestically-oriented firms collapsed.  The former were outstanding relative performers in a terrible overall market.  But investors made little actual money by holding them.

–US post-1974.  During the subsequent several years, the market went sideways.  But large stocks went down substantially while smaller companies like Wal-Mart or Toys-R-Us went up like rockets.

The difference in these two cases?  In the first, local investors were unable to distinguish between the fortunes of the overall economy and those of individual companies.  In the second, they were.

Today?  Traditionally, American investors have been highly skilled stock pickers–by far, the best in the world at individual stock analysis.  But the rise of trader-run, commodity/derivative-oriented hedge funds since the turn of the century has refocused the market to some degree.  And the firing of the most experienced brokerage house analysts in cost-cutting moves over the same time frame hasn’t helped.

My bottom line: I think individual stock selection will turn out to be very lucrative in the mildly uptrending market I envision.  But the ride could be unusually bumpy, due to political and hedge fund headwinds.