“It is not the strongest of the species that survives, or the most intelligent that survives. It is the one that is the most adaptable to change.” —Charles Darwin

2008 in Review: Has the Easy Market Call Come and Gone?

As regular readers know, I've had a cautious, even bearish view, towards equities and credit over the past couple of years. The handwriting was on the wall and both seemed woefully overvalued. That being said, my long-standing target for the S&P 500 of 750-800 was reached this autumn, a level that has held, even in the face of awful economic news. I do believe an ultimate low of 500-600 is possible, but most of the pain (in terms of price, not time) has been faced.

Some people will tell you that the bad news is now ‘priced in’ for the S&P 500, but I strongly disagree. According to S&P, its ‘top down/macro’ earnings estimate for 2009 has fallen all the way to $42 per share. This is in direct contrast to the cumulative ‘bottom up/stock-by-stock’ estimate of $70 or so from Wall Street analysts. The Wall Street folks have been overly optimistic for 20 years or more while S&P has a habit of being on the mark since they don’t have an axe to grind.

My point is that while the S&P 500 has moved from nearly 1,600 to a recent 860 (a 45%+ decline), it remains at a healthy 22 times S&P’s earnings estimate for 2009. Bulls will tell you that the market is cheap because even if the $42 earnings number is correct, these are ‘trough’ earnings - or the low point for the cycle. I'll concede that even if the $42 is a trough number, the market is not cheap on any other metric, price to book, dividend yields, etc. In addition, P/E ratios based on trough estimates assume that earnings will rebound sharply once the bear market is over, but this is certainly not our outlook.

I must concede that the easy call being out of stocks or underweight stocks in general has been made, and is now probably past for the most part. For 2009 and forward, a general call on the overall market won't be as easy, but good money can be made in company selection and sector rotation.

While equities in the US suffered 40% losses for 2008, corporate bonds and other credit-sensitive securities got killed (some ‘core’ fixed income managers were down as much as 25% for the year). The pity about 2008 for most investors is that they were let down by what was supposed to save them: diversification. 2008 will be remembered as the year of the ‘1 beta event,' a year where there was nowhere to hide, except in Treasury notes and bonds. 

My firm fully expected the ‘1 beta event,’ which explains why we were nearly void of equities (for clients that allow us to go to a 0% weighting) from April until our buy in the 750-775 area in the S&P in November. While my firm isn't close to being bullish about stocks in general -- or even credit in general -- I believe that pockets of value are beginning to develop in some risky asset classes. I also believe that we'll enter a period of Darwinism where the best managed companies pick up the pieces of poorly managed companies that will likely fail. I believe that Darwinism will occur at the national, corporate, municipal and individual level.