Why the S&P500 will tumble to 1,100 this year

Optimism is back and the US consumer will once again save the day by going even deeper into debt! The US economy has been a productivity miracle for decades and will continue to be for eternity! Bernanke is aggressively stimulating the economy by lowering rates! The flexibility and hard work of Americans will make them dodge the credit crisis!

This is apparently what investors believe about US stocks. The S&P500 has been edging higher since the last low on March 17 and is now almost 15 per cent higher. We have, however, many reasons to believe that we are close to a turning point in stocks and the S&P500 will fall towards the 1,000-1,100 range in the next couple of quarters.

The decade-long stream of debt-financed consumption is stopping right here.

Banks are no longer willing to lend money to each other, as witnessed by the widened spread between Libor and short-end government rates.

The latest Senior Loan Officer Survey from April 2008 also showed tightening in lending over the past half-year is now even more significant and reaching historical extremes.

Consumers are reacting to this in two ways – by increasingly shifting their source of financing from bank loans to credit card companies, and by scaling back on luxury purchases. McDonalds is now seeing the first decline in sales since March 2003 and domestic vehicle sales are the lowest in 15 years. In other words, personal consumption is being scaled down across the board to accommodate higher energy and food prices, and tighter financing conditions.

What we are witnessing is not negligible. It is a change in a megatrend that started in the 1970s with the abandonment of the last remnants of the gold standard when President Nixon closed the "gold window". Now, the global financial system is purely based on fiat currencies and uncontrolled credit creation. In the past decade, Chinese and Indian industrial production has increasingly come to dominate global trade flows.

Thereby, cheap Asian stuff has kept European and US inflation low despite money supply figures going through the roof. In other words, central banks have been able to keep rates at extremely low levels in especially the past 10 years.

In fact, for the past four decades, the policy answer to just about every macroeconomic ill has always been the same – more easy credit, lower interest rates and, to an increasing extent, financial engineering at governmental level to bail out failing financial institutions.

This policy response is the complete opposite of what a free market should do: uncertainty should foster a higher risk premium.

In times of turmoil, uncertainty and economic contraction, interest rates should go higher. But central banks are, in general, doing whatever they can to force them lower.

Instead of rationing capital and letting unfit investments be liquidated, central banks are flashing a false signal with low interest rates and attempting to persuade investors to continue their useless projects.

This mechanism has created a very unhealthy negative feedback debt cycle. Unhealthy investments have been undertaken due to expansive monetary policy and whenever reality knocks central banks cut rates even more aggressively.

The primary result has been widespread speculation and bubbles in stocks, bond and real estate. Another result was a complete evaporation of something as old fashioned as savings.

So, lower rates simply do not matter any longer. Even with rates at record lows, the debt burden has become so big it is unbearable and the risk associated with it has become so large that banks now shun it. Banks, therefore, are reluctant to lend money to each other or to consumers that might experience dramatically dropping or outright negative home equity. An analysis of the US economy does not leave a lot of room for optimism for stocks. We believe it is inevitable the US economy will come to a grinding halt and end in recession beginning in the third or fourth quarter of this year.

With (expected) EPS still historically high for the S&P500 and a P/E trading above 23, there is still room for a lot of downside.

The historical mean P/E is 17.9 (1970-2008). In the past recession (2001-2003), EPS expectations were revised lower by around 35 per cent from peak to trough – that is, during a time span of two years. Current figures only indicate revisions to the tune of 10 per cent for 2008 and 2009 earnings.

A combination of an additional 20 per cent downside for EPS and 20 per cent downside for P/E would indicate the S&P500 could go below 1,000.

We do not think this will happen, since non-financial corporations have been more conservative in the current recovery, and the lower dollar is helping US businesses. We maintain an end-of-year target of 1,100 for the S&P500.


  - The author is Head of Strategy at Saxo Bank



US snapshot

  - The number of months' supply of homes for sale at current monthly sales volume has increased from four to 10. Prices therefore need to be a lot lower before the housing market begins to clear. In my opinion, home prices will drop by another 15 per cent in the next year.

  - Total Housing Wealth (as measured by home equity) has for the first time since the Great Depression reached a year-on-year change below 2 per cent – now for at least two consecutive quarters.

  - Profit margins are under pressure with producer prices running at more than six per cent year-on-year and crude oil trading at $130. Financing has become difficult and expensive.

  - The unemployment rate is now, finally, beginning to rise. And looking at 30 countries since 1970, the historical correlation between house prices and unemployment rates is extremely stable. The average increase in the unemployment rate is 80-100 per cent two years after the housing market tops out. US home prices topped in mid-2006 so softening of the labour market is a bit late historically, but we still expect unemployment to hit at least 7 per cent within the next two years.

  - Home-owners are falling behind. The number of delinquencies as a share of total mortgages is now almost six per cent and rising fast. 

  - The overall activity level of the US economy is declining fast. The Saxo Bank Fundamental Index for the US economy, which incorporates 13 different indicators, is showing the worst sustained contraction since 2000-2002. Our interpretation is consumers no longer have any bubbles to invest in.
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