Gary Shilling Predicts the S&P 500 Could Fall to 600

By on December 21, 2008

Over a year ago, Gary Shilling was one of the few commentators to foresee the trouble that was coming and which should have been obvious to the many if they had done any real analysis. Shilling forecasted that we would see deflation, a rare occurrence in modern times, and he was right on this. Shilling was also correct on what seemed like an outlandish forecast that the yield on long-term treasury bonds would fall to 3%.

Mr. Shilling provides facts and figures to back up his views and analysis unlike most major investment houses on Wall Street. I have taken the liberty to paste some of the more interesting observations and facts from his most recent letter. The complete transcript with quite a few revealing charts is available at the link from John Mauldin’s website below “source” at the end of this post. It is definitely one of the more enlightening letters you will find regarding the current state of affairs.

Semi-Annual U.S. Economic Outlook: Collapsing On Schedule (excerpts):

Housing starts have nosedived from 2.3 million, seasonally adjusted at annual rates, in January 2006 to 791,000 in October, a post-World War II low.

Curiously, a survey found that in the second quarter, 62% of homeowners believed their houses had appreciated in the last year even though 77% had fallen over that time and only 19% had risen, according to Zillow. Another survey found that 91% believe that a house is the best long-term investment. A third poll revealed that 32% think this is a good time to buy stocks, but 51% believe it’s a good time to invest in a home. We wonder if that optimism will persist if our long-held forecast of a 37% peak-to-trough decline holds.

The destruction of the American Dream of homeownership for so many people will force a political response, even though the cost of subsidizing their mortgages down to their house values would be about $1 trillion.

Hedge fund redemptions are expected to jump early next year.

Many endowment and pension funds have been hard hit, especially those with heavy alternative investments in hedge funds, private equity funds, venture capital, commodities, currencies, emerging market stocks and bonds, real estate, junk securities, etc. Diversification is a great idea — if it works! But as we’ve noted continually in Insights for more than 10 years, there are tremendous amounts of hot money flowing around the world. And whether it’s managed on the basis of fundamental factors, momentum, technical analysis, etc., it all tends to end up on the same side of the same trade at the same time.

So when stocks get clobbered, as they have since October 2007, and force out hot money, it will also retreat from otherwise unrelated long positions in, say, grains, to conserve capital. Many institutional investors believe in the Modern Portfolio Theory of diversification, but erroneously thought that alternative investments would have zero or better still, negative correlation with their basic equity holdings. They also became convinced that commodities and foreign currencies were asset classes like equities and bonds, and merited 5%, 10% or 15% of their portfolios. They’re learning the hard way that all those correlations have proved to be close to 100% and that commodities and currencies aren’t asset classes but speculations.

Even though the majority of the $700 billion TARP money is yet to be committed, that total is only a small piece of the $4 trillion-and-counting sum the federal government has made to bail out the financial sector.

SUV and other vehicle owners who are now upside down on their auto loans due to weak used vehicle prices have limited zeal to keep up on loan payments.

Current quantitative easing by the Fed may not be any more successful than it was in Japan since the global financial system is in a classic liquidity trap, as in the 1930s when bankers were defined as people who wanted to lend to those who didn’t need to borrow and didn’t want to lend to those who did. Today, banks don’t want to lend to anyone but the U.S. Treasury.

Americans, especially postwar babies, have saved little for retirement as they concentrated instead on spending. The nosedive in stocks has only made retirement prospects more bleak. In the last 15 months, $2 trillion has disappeared from workplace retirement accounts, including 401(k)s, which now are the primary saving vehicle for 60% of employees.

Estimates are that 6,100 U.S. stores — ranging from mom-and-pops to major chains — will fold this year, up 25% from 2007, and followed by 14,000 stores in 2009.

We’re forecasting the most severe recession since the 1930s with a 5.0% decline. You may think that a 5% decline is not a lot, but bear in mind that recessions are more interruptions in growth than economic collapses — growth that business, consumers, employees and government assume will continue without interruption.

Obama says his proposal will create 2.5 million jobs over two years. But as discussed earlier, payroll declines are likely to continue to run 500,000 per month, so his program would only offset five months of recessionary losses.

Now the tsunami is being reflected back to the financial side of the pool in three ways.
First, retrenching consumers will keep pushing up delinquencies on credit cards, home equity, auto and student loan debt, which will result in big writedowns for their many institutional holders. Collectively, these four categories amount to $4.4 trillion, dwarfing the $0.7 trillion in subprime loans.

Commercial real estate debt is the second problem area, and of the $3.5 trillion outstanding, $800 billion is in commercial mortgage- backed securities and $2 trillion in commercial mortgages held in regional and community banks. As vacancies rise, big writedowns will follow.

Third is nonfinancial leveraged loans and junk binds. Delinquencies have barely risen from rock bottom levels, but will as anticipated by yield spreads and 20% junk bond yields. Recession-depressed revenues here and abroad, collapsing commodity prices and the leaping dollar that will turn earlier currency translation gains to losses, will all slaughter the corporate earnings of nonfinancial corporations, so far relatively untouched by the financial recession. So delinquencies and charge-offs of junk securities will leap and many investment-grade debts will be pushed into junk territory. Junk bond spreads vs. Treasurys now imply a 21% default rate, higher than in 1933 at the bottom of the Depression. Financial institutions also own a lot of the $3.7 trillion in leveraged loans and junk bonds.

Shilling’s Forecasts:

We expect the dollar to keep rising for the next 5 to 7 years, continuing the long-run pattern.

With our forecast of a severe recession, we look for corporate profits, as defined by the Commerce Department, to fall 48% from their peak in the third quarter 2007 to the fourth quarter 2009, and to drop 32% from 2008 to 2009.

Our forecasts imply S&P 500 operating earnings of $40 per share in 2009, down 35% from our $62 estimate for this year. That may sound extreme, but not for the most severe worldwide financial crisis and deepest global recession since the 1930s. At stock market bottoms, the S&P 500 P/E tends to be in the 10-12 range. But low interest rates normally push up P/Es and 10-year Treasury now yield 2.66%, and will probably be even lower later while 30-year Treasury bonds are now at 3.0%, our long-held target, and also a low in recent decades, but may drop further.

So a P/E of 15 at the stock bottom sounds reasonable, but would put the S&P 500 index at 600 then, down 32% from here and 61% below its record close on Oct. 9, 2007. Wow! Earlier, we warned of the number 777, not the Boeing airliner model but the low on the S&P 500 in 2002. If it were breached, we noted, then the bear market that started in early 2000 would still be intact, and all of the rally from the 777 low in October 2002 to the peak five years later would merely be a rally in a bear market. Last month, the S&P 500 fell below 777. It has since bounced, but probably not for long as new lows lie ahead.

Deflation results from overall supply exceeding general demand. We have been forecasting the good deflation of excess supply, as in the late 1800s and in the 1920s, due to today’s confluence of semiconductors, the Internet, computers, biotech, telecom and other productivity-soaked technologies. But we have allowed for the bad deflation of deficient demand, as in the 1930s, if one of two adverse conditions develop — widespread financial crises and worldwide protectionism. Sadly, both are real possibilities.

In peacetime, deflation reigns. Starting with rearmament in the late 1930s, then World War II and the Cold War with its hot phases, Korea and Vietnam, wartime and inflation persisted for 60 years.

For now at least, all that money from central banks and governments isn’t getting outside financial institutions. We’re in a liquidity trap. The horse isn’t drinking, thank you very much. And if lenders do start to lend, central bankers, with their congenital fear of inflation, will no doubt reel in all that extra credit.

Even if the bank reserves stimulate the money supply with the usual multiplier effect, the credit created will pale in comparison to the destruction of derivatives and other privately-created liquidity due to persistent deleveraging and writedowns.

Finally, the consumer saving spree we’re forecasting will probably increase the saving rate by one percentage point per year on average for the next decade. That would generate a cumulative $5.5 trillion and go a long way to offsetting the intervening fiscal stimuli, and then some.


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