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It is All About Valuations

And speaking of direction, let's return to a theme I spent almost six chapters on in Bull's Eye Investing, and numerous e-letters. It is my contention that there are very long term cycles in the stock market. But rather than look at bull and bear cycles in terms of price, we should look at them in terms of valuations. Markets go from high valuations to low valuations back to high valuations, ad nauseum. You can measure it in price to book or price to earnings or whatever metric you want. The affect is the same. There has never been a time where markets started out from high valuations that they did not eventually end up with lower valuations. These cycles lasted on average for 17 years, with the shortest being 13 years (so far).

And this is important. There has never been a time when valuations dropped to the mean and then went back up again without visiting a much lower valuation. Never. Not one time. Zip.

We are now back to the mean P/E ratio. Now maybe this time it is different. But those are dangerous words.

Let's take a look at a chart from Dr.Woody Brock, of Strategic Economic Decisions one of my favorite economists as well as one of the smartest I know.


Click to enlarge image

If you invested in 1999, you are essentially where you were 8 years ago in terms of price. Note that Woody uses the third quarter of 1999 as his comparison, as the market was close then to where it is now. But earnings, as Woody points out, have risen by 110% since 1999. P/Es are now in the 15 range. But I contend they will go lower. How can we get to the low P/E ratios that have prevailed in all previous cycles?

Either one of two ways. The market can drift sideways for a long time while earnings continue to grow, or the market can drop enough to get us to lower valuations. And that is precisely what I wrote in this letter and my book 4-5 years ago. I said it would likely take two recessions (at least) to get us back to low valuations to set up the next bull market where the primary driving factor is expanding P/E multiples. Remember in the last bull market, 80% of the increase in the price of stocks can be explained as the P/E ratio rising from a low of 7 to a cycle high of 42.

If the stock market were to drop 20%, then the P/E ratio gets to 12, assuming earnings don't fall. Of course, they will, but they are also likely to rebound as quickly as they did after the last recession.

Now, let me speculate. Go back to 1974. Were we at the low in terms of valuations at that time? No, the P/E was 11, which is admittedly low, but it was going to 7 in 1982 (note that took another eight years).

But the recession drove the S&P 500 to its cyclical price low, an average of 82, and a relatively young Richard Russell (he was just 48 or so) famously said a new bull market was beginning. It was another 8 years and two recessions until the absolute bottom in terms of valuation was reached, but the price bottom made its entrance in 1974.

Could that happen again? Could this current recession drive the market down enough to set a price low, even though it will take some time for valuations to reach their cycle lows (and who knows what that number is?) That is very possible. There is a buying opportunity in our future.

As I said in my annual forecast, I expect to turn modestly bullish on the stock market when this recession has played its course, and seriously bullish when valuations get lower. I am looking forward to it. It is more fun to be bullish. You get invited to more parties.

Why don't we just hit the mean P/E ratio and just bounce back on up? It is mostly psychology, and I spent a great deal of time in my book and in this letter trying to demonstrate the reasons behind these cycles. But in a nutshell, if you disappoint the market once, you get a small reaction. Disappoint investors again and the reaction is more pronounced, and don't even go there a third or fourth time.

Recessions produce earnings disappointments for a variety of reasons: reduced consumer spending, higher marginal cost of sales ratios, reduced business investment, etc. I think we are in for a few quarters of disappointment.

That being said, there is always a tug of war between the bulls and bears, as the data is rarely one sided. Let's go back to Woody's recent letter, which I think captures the spirit of the debate perfectly:

First, the magnitude and indeed the nature of the credit market crisis is very hard to assess.... No one has a clue as to the extent of write-downs that will be incurred in the future. Also, from a Main Street perspective, no one seems to know how much the current or future financial crisis will impede the flow of credit needed to maintain real economic growth. The combination of diminished bank capital and tighter lending standards could prove fatal to credit creation.

Second, the behavior of the economy—the consumer in particular—is completely paradoxical. On the one hand, the economy has not been that bad at all. As former Fed Chairman Greenspan pointed out on the 25th of January, there is still no hard evidence that a recession is underway. Indeed, personal income was up 6.1% for the year ending in November. Consumption growth in the fourth quarter of 2007 was up 2%, far higher than many bears predicted. Finally, the unemployment rate has not risen very much at all. Importantly, these conditions hold true two years after the advent of the housing crisis and four years after the advent of sharply rising oil prices.

On the other hand, in contrast to this reassuring picture of macro-stability, the rate of loan delinquencies and defaults of household debt of all kinds is arguably at its highest level in history—and this is true before the unemployment rate has risen cyclically, and before a recession has occurred. Specifically, delinquency/default rates have soared across the board on auto loans, credit card debt, home equity loans, prime mortgages, and of course subprime mortgages. All this suggests that certain bears may be right in arguing that the consumer has reached a breaking point.

How might we read such confusing tea leaves? Economic bulls claim that macro-stability is once again in evidence, and that bears about the economy have been too pessimistic, as indeed they have been for a quarter of a century. But such bulls cannot explain the loan delinquency and default rate phenomena. Bears on the other hand have proven much too pessimistic in their forecasts to date. They were shocked by the 4.9% third quarter GDP growth rate, and cannot explain why the economy has remained as buoyant as it has been. Yet they can claim 'I told you so!' when it comes to the household debt crisis.

So, John, back to your original question. Will we see a depression? The answer is it is very unlikely. Most of the economy is just fine. Yes, we have a housing bubble that will take at least another 12-18 months to work through the excess inventory. And yes, we do have a credit crisis that is the worst since the Depression.

But the monetary and regulatory authorities are quite aware of the problems. You are already seeing banks being allowed to borrow at special "windows" (the TAF or Term Auction Facility) to meet reserve requirements. Banks are being given time (as I understand it) to meet SIV problems. The Fed is lowering rates at a rapid pace.

There is a serious effort to figure out how to capitalize the monoline insurance companies. I think it is not unlikely that public money will eventually be brought into play, much like the Savings and Loan Crisis on the late 80's. In short, and no matter what your view is, the Fed and the Treasury are going to do what they have to do to keep the game going. My bet is that the Sovereign Wealth Funds have just begun their fire sale investments, as there may be another few hundred billion to write down. So be it.

But it will mean that we Muddle Through in the meantime. It will probably not be pretty or elegant. It may not be fun. No one is going to guarantee your 401k accounts. Shareholders in large financial institutions that still have large write downs in their future will not be happy as some banks will just keep disappointing.

I still maintain the Fed is only marginally interested in the stock market. But the banking system is on their watch, and it is in a full blown crisis. They are paying attention. Can they do enough to avoid a recession? I don't think so. But they can keep it from becoming a major recession or depression.

In the meantime, 93% of people will have jobs (at the worst). There will be the usual lowered expectations, and businesses will have to adjust. New businesses will be started that will change the world. Entrepreneurs will see opportunity. Investors will see the auctions of foreclosed homes as opportunities to own rental property at once in lifetime values. Well, ok, maybe twice in my lifetime, as the above mentioned S&L crisis did create some great opportunities in specific locales.

It will take some time to work through the after shocks of two bubbles bursting. But we will. And thus, Muddle Through will be the operative words to describe the economy. And then things will return to "normal."

Remember, new opportunities will present themselves, just as they have after every recession. In fact, they are often the best ones, as you can find them at lower costs.

Breathe deep, Dr. E. It is just a recession. This will pass. Besides, you are a doctor. There will be no recession in health care. Party on.