The Jackson hole

I haven’t seen a single commentator predict that QE3 will be foreshadowed at the Federal Reserve Jackson Hole meeting this Friday (US time).

The blogospheric consensus is that instead, we’ll get ‘Operation Twist’, a contorted effort to stimulate without stimulating by manipulating the yield curve. Calculated Risk, the FT, and Gavyn Davies all provided commentary on the likely shape of any announcement yesterday and Soc Gen adds more today.

This is all well and good and I agree that it is both desirable and likely to hold back outright QE3. So, where does that leave market valuations? In my view, pretty much up the creek.

Why do I say so? Simple, equities have not priced the effects of a Western recession on earnings. And commodities have not priced the effects of a recession on demand. For the latter, here’s a chart of the CCI:

I mean, come on, we have hardly retraced a jot of QE2, let alone priced a Western recession.

For equities, a Short View video from the FT sets up a clear framework. It describes the S&P500 forward price/earnings ratio of 10.3% versus an historic average, since 1985, of 15.5%. But it also makes the point that this is based on projected earnings per share of $108. During the last recession earnings dropped 40%. That would make the forward P/E 17%. The video goes on to outline reasons why we can regard current equities sentiment as already depressed, which could signal a bottom. Hope springs eternal.

We can build on this framework using a neat guide from Goldman Sachs via Zero Hedge:

Every 50 bp shift in 2012 GDP growth rate translates into about $2 per share in 2012 EPS. For example, if the US economy stalls and registers no growth in 2012, then our EPS forecast would equal $94, about $8 below our current estimate and 2% below 2011. If US GDP contracts by 2% on a year/year basis then 2012 EPS would fall to $82 reflecting a 14% decline from 2011.

Many investors are surprised that the EPS sensitivity to GDP growth is not more sizeable. One explanation is that a meaningful portion of aggregate earnings is only modestly linked to GDP growth. Utilities, Telecom Services, Consumer Staples and Health Care will account for nearly 30% of 2012 EPS. We recognize that federal and state government austerity next year will likely have a negative impact on earnings for certain sub-sectors of Health Care. Information Technology, Energy, and Materials generate a large portion of their sales outside the US, in some cases more than 50%, and pricing for commodities reflects global supply and demand. These sectors account for 36% of our 2012 S&P 500 EPS.

So, if you believe, as I do, that a pretty decent US recession is baked into the cake, along with a new unemployment and inventory cycle, then your looking at a minimum fall in earnings to below $90. At $90 and without any further P/E compression, that gives you an S&P value of 927 versus the current 1123. And that’s before we price any further fallout from the demise of Europe.

So, we are still well above any recession pricing. Indeed, according to Morgan Stanley via Alphaville, European equities are not even yet priced for slow growth:

During the 5 periods of sub 2% growth since the 1970s, earnings have always fallen by at least 30%. Exhibit 3 shows the same data but as a time series. Since 1971 there have been 5 separate periods of sub 2% GDP growth, and as illustrated in Exhibit 4, in each instance there has been a coincident earnings recession, each of 30% or more. Four out of those 5 periods occurred during economic recessions. The one exception to that was in the aftermath of the TMT bubble, when there was no official recession. We see two factors indicating that earnings declines may not be as severe this time around. Firstly, in our base case, we forecast very low economic growth but no outright recession, although this is a very real possibility. Secondly, we haven’t seen the same level of corporate hubris in terms of expanding capacity and adding layers of costs that preceded the post-TMT 2001-02 earnings recession.

Alphaville adds:

Earnings fell 40 per cent while the real economy grew 1.5 per cent from 2001 to 2003.

I have little faith that ‘Operation Twist’ activities will arrest this. Heavy sits the crown for Ben Bernanke this week.