How Low Will We Go?

I’m not sure what to make of the market today.  On the one hand, the S&P dropped 2.36% to set a new cycle low, closing at 735.09, with an intraday low of 734.52.  Clearly, closing at the lowest level in 12 years is not good news.

But, the economic news today was horrible.  Q4 GDP numbers were massively revised down, GE slashed its dividend by 68%, Citi had another massive infusion of taxpayer dollars, GM is truly on the precipice of bankruptcy, etc.  The S&P could easily have dropped more.  And 735 is just 2% below my approximate “fair value” number of 750.  Signs of resilience?

On the other hand I’m reminded of this quote that I posted earlier:

The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to ensure that as few as possible escaped the common misfortune.

- John Kenneth Galbraith, “The Great Crash”

And, it’s time to look at the Four Bad Bears chart again.  It looks a lot like 1929.

The Real Problem?

Let me preface this by stating that I am an unabashed capitalist.  I believe in the free markets and the entrepreneurial spirit that makes our economy the most robust in the world.  I am confident that these forces will lead us to recovery in due time.

But let’s be clear about the root cause of the current crisis. We are in the current economic crisis because the banks are publicly traded.  Before you burn me at the stake, listen to my argument.

Daily Dose: Nationalize the Too Big to Fail Firms?

I have not posted on this topic lately.  When I first started talking about it a couple of months ago it was not a daily news item.  But I’m no longer ahead of the curve here and can’t add too much to what you can read everywhere else.

But, be sure to read this post from Krugman.  The take-away message is that with the actions being taken by the government, the Japan Scenario is looking more and more likely.

The main issue is that we continue to refuse to nationalize the banks.  It turns out that the “stress test” isn’t very stressful at all. And, as Bernanke and Geithner have stated this week, we will continue to fund the banks, letting them burn through our cash, without requiring any real change on their part.

The Japan Scenario is better than Great Depression II but it is not as attractive as the Swedish Model (rapid bank nationalization and restructuring) in my opinion.

Long Road Back

After the Crash, Stocks May Face Long Road Back, that’s the title of an article in the WSJ’s personal finance section.  It refers to research from professor Elroy Dimson at the London Business School.  Based on analysis of 17 markets around the world looking back to 1900, Dimson “estimates that we’ll have to wait nine more years before the Dow average, including dividends, has a 50% chance of hitting its 2007 highs.”

The Case for the All-Bond Portfolio

Conventional wisdom in the financial services industry is that bonds are only to be tolerated as a hedge in a well constructed portfolio.  Anyone who knows anything about long-term asset allocation knows that stocks are the only investment that will provide a reasonable chance for growth that outpaces inflation.  “Stocks for the long run” is not only the title of a popular investing book, but a mantra in my business.  In fact, I am strongly encouraged to run computer simulations for clients that clearly show the need to have heavy allocations to stocks.  This is true even with retirees.

Not everyone agrees with this position, but they have largely been marginalized.  But, here is interesting commentary from a husband and wife team that has successfully invested only in bonds since the mid-1970s.

Another View

I was sent some commentary from a strategist at another firm.  Here are some highlights:

By the time this is over, we could be slapping a classic recession trough multiple of 12x on an earnings stream that is closer to $50 than the current consensus $70 EPS estimate (as an aside, the multiple has troughed in single digit terrain half the time, in both deflation and inflation times).

(It) goes without saying that there is likely no bottom in the overall market until the (financials) group finds a trough – which means that not only are we talking about a “6-handle” on the S&P 500, but that we probably have at least another six months of this bear phase. We have said time and again that investors should stop timing the end of the bear market, but for those who simply cannot resist the temptation, here is our view:

• The market will bottom six months after the financials find their trough.
• The market will find a confirming bottom once it crosses above both the 50- and 200-day moving averages. [DI: the S&P 50-day is now about 840 and the 200-day is about 1000. So we need a big rally or a lot more sideways action to cross both of these moving averages.]
• The market bottoms 4 months before the recession ends (this is the average and median lag going back through 100 years of data), which we do not expect to see before the first quarter of 2010.
• Bottoms form when fear overwhelms long-term resolve. Fear has yet to set in, beyond say a few days. So what has to happen is what happened in June 2002, when the Sept/01 intermediate low was not just broken but it was punctured and continued to slide each day until we did get that fundamental bottom in Oct/02 – which was 20% below what was perceived to be the end of the market more than a year earlier (i.e. call us at 600 on the S&P 500 – that may be the level to start putting cash to work). [DI: I have mentioned repeatedly of late how we could get to 600, but I have to strongly disagree that fear has not set in. I think we've been seeing panic for months.]

Net: the final market bottom is Q4 of this year and we have another 22% to drop in the S&P.  Ouch.  I’m not endorsing this analysis, but it is plausible.

It Was Just One Day

Today merely erased Monday’s loses.  Bernanke’s speech did not turn around the markets.  The economic news today continued to be terrible.  But, the market is fairly priced right around 750 and the markets know it.  The trading range holds.  BTW, using Schiller’s method of calculating, we’re currently at a P/E of 13.  That’s good news.  15 is the long term average, 10 often marks the end of bear markets.  I expect more sideways for months if not longer.

Will Tomorrow be the Day?

I don’t pay much if any attention to the Dow Jones Industrial Average (DJIA).  The Dow is the oldest index and is very widely reported, but it only covers 30 stocks and, like the name implies, only from one sector of the economy.  While the Dow has moved to new lows, I’ve been watching the S&P 500.

Within my business, the S&P 500 is more widely watched.  It covers 500 stocks, from all sectors of the economy, and represents approximately 75% of the total market.  As such it is an excellent, broad barometer of investor confidence.

On Oct. 7, 2007 the S&P hit an all-time high of 1576.09.  Since then the intraday low was reached on Nov. 21, 2008, at 741.02.  That’s a decline of 52.98%.  Today, the S&P closed at 743.33, but traded as low as 742.37.  So, the Nov. 20, 2008 low still holds, for now.

I heard a report today that “consensus” earnings estimates for the S&P 500 for 2009 are now 50.  If you put an “average” P/E on that you get a fair market value of 750.  Using that metric, the market is now fairly priced.

However, markets tend to over correct.  Bear markets traditionally do not end until the P/E is under 10.  If that holds true this time we can get to that 10 P/E in one of two ways.  The most painful would be a continued decline in the markets; a P/E of 10 on earnings of 50 is a value of 500 on the S&P.  This would represent a drop of 68.28% from the Oct. 7, 2007 high.  Brutal, but not unprecedented; the NASDAQ dropped more earlier this decade.

The other way to get to a P/E of 10 would be for a lengthy sideways market.  If we trade in a tight range, the price will remain somewhat constant and eventually earnings will increase, thus reducing the P/E.  It might not be until next year, but earnings will rebound.  This scenario has been my operating model.

The rapid deterioration in the markets over the past few weeks, however, is putting serious strain on this model.  Tomorrow’s movement will be telling.  Will we hover around a “fair” price of 750 or will we over correct and start the fall to something as low as 500?  What will the animal spirits compel investors to do?  What theory of behavioral investing can we summon to guide us?

No one knows.

The Pessimism Bubble?

In the world of economics blogging there are a few that stand out for providing good research (as opposed to mine, which is more like rambling commentary).  One of the more respected blogs is Econbrower, an offering from two economics professors, James Hamilton and Menzie Chinn.

Menzie has a post today that compares industrial production and manufacturing output drops in our current recession with prior recessions since WWII.  As usual, this data shows another record drop, reinforcing all the talk about the “unprecedented” nature of this recession.

But then, in response to reader comments, Menzie posts this:

I am going to repeat my predictions here just so that the record is thoroughly visible.

1) The recession trough, by NBER definitions, will be in Q309.

2) Jobless recovery persists into 2010.

3) Employment will ultimately bottom at 131M jobs (i.e. 3.5M more to be lost from this point on). The UE rate crosses 10%.

The funny thing is, my predictions for a recession totaling 20-22 months in duration and 7M jobs lost peak to trough is still widely derided as ‘delusionally optimistic’. So even though my prediction accounts for the longest duration and biggest percentage job loss of any postwar recession, people here still soundly dismiss it.

I have been consistent, and will stick by my predictions.

Pessimism, too, is prone to bubbles. The pessimism bubble is close to peaking. (Emphasis added.)

I certainly hope Menzie is right, but he is definitely in the minority at this point.  If he is right, that helps put a floor under stock market but it does not necessarily signal the return of a bull market.  We have decades of excesses to wring out of our economy.

A Nervous Day

My operating model has been that we are in a prolonged sideways market.  We will be bound in a trading range with the Nov. 20, 2008 close (about 750 on the S&P) as the low and a top end as high as 950.

These are rough ranges, and we could set a new low, but my assumption is that it will not be too much below 750.  My model is that we will trade within this range for some time – perhaps for the rest of this year.  Any breakout will be temporary until some significant new economic news occurs.

Yesterday we had yet another plunge in the markets and we came close to the low end of the range, so market action today was important to watch.  Would we have a collapse?  Bounce off the bottom?

Compounding my concern was the drumbeat of terrible economic news, including reports on the Fed’s warning that 2009 will be much worse than previously thought.  So much for a second half 2009 recovery.

But most troubling to me has been the lowering of forecasts for 2009 S&P 500 earnings.  If we assume the S&P is 750 and use an “average” P/E of 15, this implies earnings of $50.  Up until recently, this was a reasonable lower-range estimate and provided my hope for a floor of approximately 750.

Recent earnings reports and forecasts have caused many economists and strategists to lower their 2009 forecasts.  The latest number I’ve seen is $46, from an economist who is labeled a “perma bear” but who has been right lately.  Using a P/E of 15, that places a floor at 690, 8% below my floor.  But, using a P/E of 10 – a P/E that historically marks the end of a secular bear market and beginning of a secular bull – we get a valuation of 460.  A drop to 460 would be catastrophic.  It would represent a drop of 71% from the market high in October 2007.

This is certainly in the realm of possibility.  The NASDAQ dropped more than this following the burst of the Tech Bubble.  The Nikkei dropped more than this in the early 1990s.  The Dow dropped more than this in the Great Depression.

I’m not predicting a drop in the S&P to 460.  But now that earnings are being revised downward even further, I am nervous when we approach the 750 level.

Perhaps part of the resiliency in the market today came from President Obama revealing the “3^rd leg of the stool” in his economic recovery plan – help for homeowners – along with previously announced help for banks and job creation via economic stimulus.  As I have said before, none of these plans are perfect, but I am definitely of the opinion that Obama is doing the right things.