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Aug. 24, 2011, 12:01 a.m. EDT
By Robert Powell, MarketWatch
BOSTON (MarketWatch) "â? It's not a recession yet. Neither comprehensive data for July nor the more spotty data for August confirm this, according to David Kelly, chief market strategist for J.P. Morgan Funds.
But saying it's so will probably make it so. "Overall, the chorus of economists and strategists predicting recession has grown louder in recent days and the withering impact of these pronouncements on confidence is sadly boosting the chances that they could be right,"? Kelly just wrote in his weekly commentary.
Sam Stovall, the chief investment strategies for Standard & Poor's Equity Research, is also among those who are preparing for the worst. "If the market action in 2008 taught us anything, it was: Be proactive and expect the worst,"? Stovall wrote in his weekly commentary.
Given his desire to be prepared for the worst, Stovall set out to answer the following questions: How far could S&P 500 operating earnings per share fall should the U.S. slip back into recession, and as a result, where might the S&P 500 /quotes/zigman/3870025 SPX +3.43% bottom out in anticipation of these EPS revisions?
In previous cycles such as this, earnings per share would fell 15% to 20% over 15 to 19 months and stock prices would trade multiples of 12 to 13 times trailing results.
Applying that historical backdrop to today, Stovall said the S&P 500 earnings per share of 93.29 as reported by S&P's Capital IQ for the second quarter of 2011, and assuming the U.S. does slip into recession and earnings trade between 12 times and 13 times, the S&P 500 could ultimately bottom in a range of 900 to 1030. The S&P 500 closed up 39 points on Tuesday at 1,162.
Given what seems like the potential for a 20% decline in the market, would it make sense to play it safe and start adding defensive positions, or would make sense to start betting the ranch and ETFs that short the market "â? or buy some long out of the money puts, say the ProShares UltraShort S&P500 /quotes/zigman/1497798/quotes/nls/sds SDS -6.77% or the ProShares UltraShort Russell2000 /quotes/zigman/4194931/quotes/nls/twm TWM -9.52%
Here's what strategists say:
Christopher Cordaro, CFP, CFA charterholder, CEO and chief investment officer of RegentAtlantic Capital LLC, is of the opinion that the double-dip recession is a self-fulfilling prophecy. "It's the biggest risk we face,"? said Cordaro.
But whether a double-dip recession becomes a reality or not, Cordaro is of the opinion that better investment opportunities exist outside the U.S., particularly in Europe. "We've adopted the Warren Buffett philosophy of being greedy where others are fearful."?
At the moment, he's fond of two ETFs that reflect better valuations relative to the S&P 500. One is the iShares MSCI EMU Index Fund /quotes/zigman/264793/quotes/nls/ezu EZU +3.53% , which tracks the price and yield performance of publicly traded securities in the aggregate in the European Monetary Union markets. The other is the SPDR Euro Stoxx 50 /quotes/zigman/478482/quotes/nls/fez FEZ +3.87% , which tracks an index comprising leading blue-chip in the euro zone.
The SPDR Euro Stoxx 50 has a dividend yield of nearly 4.8% and it's trading at price-earnings ratio of 7.8%, while the IShares EMU Index fund has a dividend yield of 3.75%. By contrast, the SPY is trading at a yield of just 2.1%.
Yes, it's true that the crisis in Europe might get worse before it gets better, but Cordaro also knows that it's impossible to buy at the absolute bottom. Ultimately, he said, companies that make up those ETFs are large firms domiciled in Europe that derive the bulk of their income from emerging markets.
Of note, Cordaro just co-authored a paper suggesting that Robert Shiller's Cyclically Adjusted Price-Earnings (CAPE) ratio, a widely-followed measure of stock price value, might be both overly bearish and unreliable right now. For one, the current 10-year Shiller CAPE ratio includes two of the worst earnings declines in history. And two, the current period is the only time when 10 years captures two earnings declines that exceeded 40%.
As of the end of July, the Shiller CAPE ratio was at a relatively high level of 22; its long-term average is 16 and it hit an all-time high of 44.2 in March of 2000, the peak of the technology bubble.
"In seeking to remove reporting distortions by using an inflation-adjusted 10-year average of earnings, (the Shiller CAPE ratio) may be creating a distortion itself,"? he wrote. "Investors may be better served by more traditional metrics such as price-to-book value, price-to-sales, and a traditional price-to-earnings ratio today, all of which indicate that large-cap stocks are a good value."?
Read the paper, "Is the Shiller P/E Ratio Too Bearish Today?,"? here.
Other investment professionals also see more opportunity outside the U.S "â? recession or not. Jonathan Masse, a CFA charterholder, co-founder and senior portfolio manager at Baochuan Capital Management, LLC, doesn't foresee the U.S. slipping back into a recession. But he does believe that investors are greatly underexposed to China, the world's second largest economy and largest exporter.
One of the investment strategies BauCap, whose chief Investment officer is Princeton University economist and author, Dr. Burton G. Malkiel, is advocating at the moment is this: Buying the shares of the Guggenheim China All-Cap ETF /quotes/zigman/573334/quotes/nls/yao YAO +4.38% and selling in-the-money calls of the iShares FTSE China 25 Index ETF /quotes/zigman/357940/quotes/nls/fxi FXI +4.60% . That strategy will provide a dividend yield of about 4%, he said.
And still others, including Phil Cioppa, the chief investment officer at Arbol Financial Strategies, is less eager to short the U.S. market and more interested in going long outside the U.S. "Until Europe develops a way out of the Euro, internationally, the only ETFs I am using that help diversify as well are emerging market countries, especially India,"? he said. "Being the largest capitalistic nation, if they can keep all socio-economic factors relatively equal, the return on those ETFs will outperform any domestic."? The WisdomTree India Earnings Fund /quotes/zigman/1512813/quotes/nls/epi EPI +2.41% , though down 33% over the past year, is the largest of the ETFs investing in India.
In the main, and for what it's worth, Wall Streeters "â? including Kelly "â? are advocating for a much more balanced approach. "For investors the unpleasantness of current volatility and fears of recession need to be balanced against current market valuations,"? he wrote. "Indeed unusually low P/E ratios on stocks and exceptionally low yields on Treasuries only seem to make sense if a very nasty recession materializes. Given this pricing, a balanced approach to investing still seems appropriate in a financial environment where neither market prices nor investor emotions appear to be anywhere close to being balanced."?
Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.
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