Farrell: Earnings Hit? Already Baked In

Life with Kudlow is always interesting. Last night's lively discussion/debate centered in part on John Mauldin's (newsletter writer par excellence) bearish view of the earnings outlook. He feels that the price level of the S&P is too high relative to what will be disappointing earnings.

I'm not sure what earnings are going to be so let's plagiarize some of Jason Trennert's work from Strategas. Jason looked at all the recessions since WW II and calculated that on average earnings fell 17% from whatever the peak had been. I don't see a recession on our table yet, but let's declare one for the sake of argument. The recent peak in earnings was the four-quarter period ending June, 2007 when the S&P earned $91.50. If we take 17% off that, and remember, those that don't study history are condemned to repeat it, then the trough in earnings will be $76. That number is far below any estimate I have seen, so that might be bearish enough.

The question then is what price to earnings multiple would be fair on $76 in earnings. Go back far enough and empirical observation of market cycles shows that headline inflation (now around 4%) and the price/earnings multiple add up to 20.There is no science behind this. That's just the way it has fallen out for the last 60 years with an amazingly small amount of deviation.

If we have a recession (not here yet!) I would guess inflation would be lower than 4%, but let's use 4%. The fair multiple would then be 16. 16 times $76 would give you a target price on the S&P of 1216. We are now at 1284. I would guess a recession would see lower inflation, so a 17 multiple on depressed earnings would be fair. That would give a target of 1292 .

You could see it as the market has already factored in a recession and a big hit to earnings! Tough to get to say all this on Sir Larry's show. (See the video for the discussion). There are actually other people on who feel what they have to say is important as well. Some nerve!

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Vincent Farrell, Jr. is a Principal of Scotsman Capital Management and a regular contributor CNBC.