History suggests earnings will weaken, markets likely to remain burdened for a couple of years

Dear Reader and Fellow Investors,

Today will be a brief blog that will focus on the very simple concept that stock prices are determined by their ability to generate profits/free cash flow.

Fair value by Graham and Dodd was determined by using the 10 year average earnings, to ensure one was not over paying for unsustainable growth. A suitable multiple is then applied to this figure.

We have mentioned in past discussions that using such an approach we feel fair value for the S&P 500 lies between 900 - 950.

Below we include a graph that shows clearly in the late 90s how the price of the S&P500 went away from the 10 year average earnings per share (EPS) of the S&P 500 index. This is not sustainable. Indeed, we know what happened next.

We can see in more recent times that the 10 year average EPS have run away from the market price. You may apply the converse that we have said, and say it is a unique buying opportunity. We beg to differ.

Rather than having a pricing bubble, in recent years, I believe we experienced an earning bubble that led to operating margins to expand considerably above average (operating margins are a strong mean reverting variable). This was fueled by strong expanding credit, as wage growth remained weak during this period for developed countries.

Though margins have started to fall over the last 18 months, pricing is not in line, in your authors opinion, with the bursting of this earning bubble. We are likely to remain in a weakly priced stock market for a couple of years.





Yours sincerely,

Alessandro Sajwani