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Looking for the Bottom

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By PhoolishPhilip
October 9, 2008

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The stock market seems to be in a free fall, the credit markets look to be ruined, people and institutions are panicking, and investors are left wondering where the bottom might be found. EliasFardo, sounding like Cramer, has suggested that things are only going to get bleaker. I happen to think he is right. Despite the recent market declines the S&P 500 is still overvalued by historical standards. According to the NY FED the S&P 500 is still trading at a PE of over 21!

http://www.newyorkfed.org/research/directors_charts/ipage20.pdf

Looking at Shillers table of historical PE ratios for the S&P 500 the current ratio is probably a little above the long term average, which in normal times might not be such a problem except that these are not normal times.

http://www.econ.yale.edu/~shiller/data/ie_data.htm

The repercussions of this financial crisis are still to be determined, but we can be certain that we will be experiencing a serious and protracted recession for at least the immediately foreseeable future (18-24 months). How can anyone justify a PE ratio of 21 for the S&P 500 on the cusp of a major economic contraction? And if this contraction turns out to be even close to the economic depression some analysts fear (and Buffett himself suggested on Charlie Rose that this could be a bad event, the worst in his lifetime) we are likely to see corporate earnings plummet over the coming year or two. That means one of two things: (1) stock prices hold their ground and PE ratios rocket to historical highs, or (2) stock prices and PE ratios collapse. In the three most serious previous market crises in 1929-32, 1938, and 1982 the S&P 500 ratio fell to 5 or 6. Even if earnings hold steady such a drop in the S&P 500 PE ratio would bring it down to about 300-400 points. I hope it doesn't come to that, but I suspect that we will see 800 before we see 1500 again. By the way, 800 is the support for a collapsing S&P 500, and it takes us back to Sept 2002.

We are witnessing, as RLosch noted, a generational event occurring in our financial markets right now. This event is the culmination of nearly thirty years of economic growth generated by the massive expansion of fictional capital, otherwise known as credit. We have witnessed growth through revolving credit expansion with the generalization of credit card debt through the consumer body in the 1980s, and the massive expansion of credit through the monetization of overvalued housing assets in the early 21st century.

http://www.federalreserve.gov/releases/g19/hist/cc_hist_sa.html

Revolving consumer debt has grown at an annual rate of 10.4% since 1980 and grew at an annual rate of 14.7% during the decade of the 1980s. One could argue that much of the Reagan recovery was debt driven as consumers were made newly flush with fictional wealth. The growth of revolving consumer debt has slowed significantly during the first decade of the 21st century, but non-revolving debt stepped in to replace that lost lubricant of capitalism. Non-revolving debt has increased at an annual rate of 6.7% since 2000, nearly 50% higher than the growth rate attained during the previous decade. Combined, these two forms of consumer debt have greatly increased the debt service ratio for homeowners, rising from 13.77 in 1980 to 17.5 most recently.

http://www.federalreserve.gov/releases/housedebt/default.htm

My point in saying all this is that past economic recoveries have been driven primarily by the generation of consumer demand in the US through debt creation, and any future recovery is not going to be able to operate through this mechanism. The economy is choking on debt, and debt (other than government debt) is not going to be the solution this time. Perhaps the center of gravity of global economic development needs to shift away from the US and the American consumer. Perhaps a new engine of recovery will emerge in the east and south Asia basins. It is unlikely, however, to come from the American consumer. And if it isn't coming from the American consumer, it isn't coming any time soon. Thus, to bring it full circle, I don't see a bottom to this market collapse any time soon. I suspect that in the coming couple of years there may be opportunities to pick up solid companies at frighteningly cheap multiples to earnings. We're getting there right now with companies like Altria, Boeing, Deere, Best Buy, Aetna, ADM, Cummins, AEO, trading at PEs under 10 and falling. There are opportunities to collect some serious dividends out there right now, if you are willing to do your research. Gannett is trading at a dividend yield of nearly 11%, and a bunch of specialized REITs are offering yields of 15-25%.

The next few years will provide enormous opportunity for the cash in hand stock pickers amongst us. For the rest of us, what, breadlines???

PhoolishPhilip