On recessions and earnings volatility

After posting the Jim Bianco article on getting defensive, I traded e-mails with Jim on recessions and earnings volatility. Here’s what he had to say after I showed him the article:

I saw it, the link Tyler had in the comment section from the FT was equally interesting. Mackintosh said the same thing, namely if earnings fall 40% over estimates, like they did in 2008, the market is overvalued.

I would finally add that I think the market knows all this. It understands if we miss a recession then stocks are cheap as they can hold the cyclical earnings peak. If we have a recession, then stock are expensive. This is why the major averages gyrate around with huge volatility, the extreme binary outcomes feed into this belief.

The link Jim is referring to was a 5 minute clip from FT investment editor James Mackintosh from late August in which Mackintosh talks about the forward P/E ratio. While I never look at forward P/Es because they are misleading, Mackintosh is on to something in that video. Stocks are not cheap if you use a Shiller P/E which is a rolling average of past earnings. And this has been true since 2009.

However, what this price movement shows is that recoveries are a double benefit via increased earnings and P/E ratios. Earnings increase and so do P/E ratios as well. The same is true in reverse for recessions. The longer the upturns and the shorter the recessions, the better it is for investors.

In fact, the hallmarks of a bear market are not in lower GDP growth but in lower P/E ratios. Five years ago, Jeremy Grantham separated historical P/E ratios into five quintiles, from years representing the 20 percent of years with the lowest P/E to those representing the 20 percent of years with the highest P/E.

Below is a chart drawn up by John Mauldin of what he found, which was bearish for investors in 2006. Unfortunately the same is true again today.

Jim also pointed to a piece by Barry Ritholtz in the Washington Post called “The investor’s dilemma: Earnings, valuation and what to do now” that I would recommend on this issue. The money quote is this:

I expect more slowing in the economy, reflected in weaker earnings and lower prices. However, I do not have enough information to see around the corner to how severe or mild the slowdown will be.

As we have suggested before, you should take a proactive approach that recognizes these various possibilities and plan accordingly. That means holding a decent amount of cash and bonds (I am at 50 percent) so you can ride out the downturn and have some buying power when things get cheap.

And I should add that another investment market I used to work in is sending a dangerous signal about the health of the US and global economy. In a good scenario, you just get a growth slowdown. I think a growth slowdown might get you to bottom at 1000 (well into official bear market territory of –20%). However, if recession is avoided we would move forward from there. So that might be the third scenario to look for in addition to the two that Bianco has laid out.

Bottom line: Earnings are volatile. Whether we enter recession or not, the upside here is limited. Investors have every reason to get defensive. If we avoid recession, holding a good slug of cash (and potentially gold in today’s world of negative real rates) gives you buying power for when the economy turns decidedly higher.