Does 2009 matter?

I got to thinking today about whether or not any of this awful economic news matters anymore. Somewhat difficult to answer but here is what I have come up with. I think it does matter because the market is already looking to 2010 with expections of recovery. Here's where it all goes sour - let's assume S&P earnings actually hit $50 for 2009 (I think this is on the high end of reasonable. In Q3 2008, earnings growth outside the financials was up 5% yoy and is only now starting to crater. Anybody wonder why GE is trading with a dividend yield of 10%. 3M should be interesting this week). And for sake of this example lets say we assume 15% yoy earnings growth in the S&P so 2010 will be $57.50. **For the record in the no-leverage era we have entered 15% yoy growth will be almost impossible.** Also lets give the 10 year treasury a 2% handle and call inflation zero.

2009

S&P 800
Earnings $50
P/E 16
Earnings Yield (1/(P/E) 6.25%
10 Year Treasury 2.00%
Inflation 0

So the question becomes what is the earnings stream worth in a lower growth / uncertain environment. Today, if my earnings are correct, it is worth 6.25% or 4.25% greater than the 10 year Treasury. Or to take on all the risk of the equity market you are making an additional 4.25%. Doesn't sound like enough to me. Okay lets go to 2010.

2010

S&P ??
Earnings 57.50
P/E ??
Earnings Yield ??
10 Year Treasury 2.00%
Inflation 0

This is a little trickier as we have to make a few more assumptions. To illustrate my point lets use 3 possible P/E's for 2010 (10, 15, 20) to derive where the S&P could trade to. At 10x earnings of $57.50 you get the S&P at 575, 15x equals 862 and 20x equals 1150. Or return from todays level would be approximately -35%, 8% or 45%. Quite a range of 1 year outcomes with earnings so uncertain.

To go one step further if the market trades at 20x earnings your earnings yield (1/20) is 5%. Or better put you will be earning 3% more than 10 year Treasury bonds. Pretty skinny. So 15x and 10x are 7.5% and 10% respectively. Your "reward" for owning equity instead of government bonds is now a respectable 5.5% - 8%. Now I am getting comfortable. However in this scenario my range of equity returns would be from -35% to 8%. Not a nice thought after living through 2008. However in a world that is rapidly deleveraging, growth is going to "muddle through" for some time. Until we have more visibility on earnings I would not get too excited.

So it appears the market is discounting 2010 earnings of about $57 with a multiple of 15. I don't believe there will be any 2009 upside earnings surprise and the only real question is whether or not we step on any more land mines. My guess is yes and with risk to the downside, 2009 certainly does still matter. I would also argue that as growth subsides the multiple you pay should also decrease. This does not bode well for the coming years.

After doing this analysis it begs the question of looking at some capital structure arbitrage. It would seems to me that corporate bonds versus equity on a risk / reward basis look pretty good right now. Big BUT here ... no financial bonds for me. I am renaming TARP to TRAP for all the "investors" who bought financials in the past year without doing your homework. More on this later.