How do you value a donut?

Stock market yammerers talk about stocks being cheap right now. Earnings on the S&P 500 are expected to come in around $67 this year, meaning that the P/E ratio is around 13 at today's 873 close. 13 may sound cheap to someone who grew up in the 90's, but compared to the last century, 13 is an average-to-high P/E. Ratios at major stock market bottoms are usually in the single digits. Put a common trough multiple of 7 on those earnings, and you get S&P 473, or about Dow 4600.

That's just the multiple; what about the E in the denominator? Is 2008's $67 the trough for earnings? Wall Street analysts think so, putting a $85.56 estimate out there for 2009 earnings. Wow, 26.6% earnings growth in what everybody keeps saying is the worst recession since the Great Depression! I can't imagine how you get there, but that's why they don't pay me the big bucks.

Let's pretend for a moment that earnings might not jump 26.6% year-over-year. Some bearish types are even suggesting that earnings might actually decline in the greatest recession since the Great Depression. But even they may be too optimistic. There's no law of physics that says that corporate profits have to be positive. Aggregate U.S. corporate profits in fact did go negative in... drum roll, please... the Great Depression. How do you value a donut?

I'm not saying that negative earnings in 2009 are likely. But earnings might be closer to zero than to glue-sniffing analysts' $85. Put a 7 multiple on $40 earnings. How does that fit?

This is obviously a bearish scenario and not the most likely outcome. But you could have said the same thing in Japan in 1993 with the Nikkei down 50%. Fifteen years later, it's down another 50%. And remember how we wagged our fingers at Japan that they wouldn't let their banks fail? That's why American capitalism was healthier: we didn't bail everybody out or let them hide bad debts on their balance sheets.

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