Roger's 1998 Short Picks Message Board

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Strategies & Market Trends : Roger's 1998 Short Picks

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To: Bill Wexler who wrote (4323)	3/6/1998 10:46:00 PM
From: Pancho Villa	Read Replies (2) of 18691

>Analysts are now starting to get concerned about the earnings slowdown and the high, speculative multiple< On a serious note: have I become like those guys that have been bearish since 1980? IMO 98 earnings and 99 on earnings growth prospects will be revised downwards significantly within the next 6 months. This should generate a significant correction. Unless leople start looking at 2000 and beyond! Arew you familiar with any of the academic explanations for the 87 crash? The argument goes as follows. Share prices are supposed to reflect the present value of future earnings [free cash flows to be more accurate] for a company with free cash flows F per share for the current year growing at a compounded annual rate g the current price per share P given the risk adjusted return on equity demanded by investors is r we have that: P = F/(r-g) historically r has been at a roughly 8% premium over the three month T bill. This premium changes with time as investors attitudes towards risk change. at this point in time the premium is probably less than 8% as people seem so willing to buy stocks, the r=5% + 8%=13% now if we divide both sides of the equation above by F we get. P/F=1/(r-g) if we consider F to be earnings per share instead of cash flow we can consider P/F to be a PE ratio (not a crazy thing to do some people substitude D for dividends in it). We can then apply this expression for the PE multiple to for example the S&P 500. I believe the current forecast for S&P earnings growth is around 8% so with r=13 and g=8 we get: P/F=1/(.13-.08)= 1/.05 =20X which seems to indicate, with the market selling at 25X that the market is about 25/20100=25% overpriced. Let's say we insist the market is now fairly priced (this I doubt). One way of justifying this statement is by the previous argument (i.e., the premium over the 3 month T bill rate demanded by equity investors is now lower since the world is now now a safer place, Greenspan has deleted the world economic cycle from our diccionaries, Russian will not bomb us etc.) let's say this premium is just 7%. Then we get r = 5% + 7% = 12% and P/F = 1/(.12 - .08) = 25X Everyone happy now I assume. Now lets say the developments in Asia [we can no longer export our growth so easily to people borrowing like crazy from our banks] and the fact that we are so late in the economic cycle pushes earnings expectations down. Not for 98 let's leave those alone. Suppose 98 earnings are met but the future earnings growth is now seen as being only 6%. This is not an overly bearish forecast. Please notice that this number is still double the healthy growth rate of 3% expected for the ecomony!(i.e., earnings will still grow ahead of GNP) I hope you agree that a downward revision in earnings expectations to 6% is probably even conservative. So with r at only 12 and g at 6% we get: P/F = 1/(.12 - .06) = 1/.06 = 17X which implies a (1 - 17/25) 100 = 32% market correction. This is the argument some wise guys used to explain Black Monday in October 87. can this happen again? Now suppose r is not really 12 but 11%. The Pancho

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