By Tom Bradley

David Rosenberg, the economist, is bearish on the economy and he’s very persuasive. His view is that we’re heading into a period of subdued growth at best, and another recession at worst. His 2011 earnings estimate for the S&P 500 is $75, well below the consensus of $95.

David Rosenberg, the strategist (same guy), is bearish on stocks. In his Globe column last week he multiplied his $75 estimate by a price-earnings multiple of 10 to arrive at a 750 target for the index (currently 1,180). He picked a 10 multiple because it is “consistent with the prevailing economic uncertainty".

It strikes me that David is double counting when he multiplies a conservative earnings estimate by a rock bottom P/E multiple. A 10 multiple is near the bottom of the historical range and is typical of high interest rate periods when earnings are strong. I would expect that if we hit David’s estimate, the market multiple will be considerably higher in anticipation of more robust earnings in the future.

To put David’s 750 market forecast in context, I pulled out my trusty Morningstar chart that shows market returns for 1, 3, 5, 10, 20 and 30-year periods going back to 1950. As you’d expect, the range of outcomes for 1-year returns for the S&P 500 (in C$ terms) is wide, stretching from -40% (for the period ending September, 1974) to +56% (July, 1983). As the time frames are extended, however, the ranges narrow considerably.

For the 10-year period ending June 30th of this year, Canadian stocks, U.S. stocks and Morningstar’s hypothetical balanced portfolio (10% cash, 30% bonds, 60% stocks) are all right at the bottom of their ranges at +3%, -5% and +2.3% respectively (compounded annually).

These two seemingly unrelated data points, David Rosenberg’s look forward and Morningstar’s look back, lead to the following observations:

  • We have just finished one of the worst 10-year periods in history for stocks. There’s a lot of bad news imbedded in prices.
  • The stock market ≠ the economy. If we need to be reminded of this, we just need to look back at the robust returns of 2009.
  • When the news is all bad, and past returns are scraping the bottom, we should be spending our time looking for the positives. I’m not suggesting that we be ‘PollyAnna’ about it (“everything will be OK … la, la, la"), just balanced. When the economic bears are hogging the spotlight, we need to look in the shadows to find the counterbalancing arguments, if there are any (see Counterpoint - It's Bad, But Not All Bad).
  • If I can pay reasonable multiples (10-14 times) for high quality companies that will grow more slowly over the next 3-5 years due to a weak economy, I’m all over that.

I don’t have a clue what the market is going to do over the next few months or year (I never do). But abysmal past returns and overly gloomy valuations are good reminders to not get too carried away with the bearish arguments.

As Peter Guernsey, my former partner, used to say, “When a stock is beaten up, you don’t need to spend time looking for the warts - they’re easy to see - it’s time to go looking for the positives”.