Fools, as I write this, the market is down around 40% from its year-ago high. Last week was the S&P 500's worst since 1933; it was the Dow's worst week ever.
Still, we know that although it will take some time, this, too, will pass. Let's take a look.
There's no question that at 14,000 or so, the Dow was overpriced. The economy was falsely propped up by the huge growth in subprime liquidity. Massive numbers of borrowers had little -- if any -- chance of fulfilling their loan agreements, which in many cases were granted for a number of illegitimate reasons including greed, poor documentation (or in some cases, none at all), and outright fraud. And it was temporarily sustained through the illusion of creditworthiness.
There were the implicit endorsements by Freddie Mac (NYSE:FRE) and Fannie Mae (NYSE:FNM), which continued to buy this paper at Congress's urging. The rating agencies, like Moody's (NYSE:MCO) and Standard & Poor's, misunderstood the complexity of the risks, assigning inflated ratings to mortgage-related securities. And the big financial institutions -- nearly all of them, from Citigroup (NYSE:C) to Morgan Stanley (NYSE:MS) -- failed to account for counterparty correlation. They were wrongly comforted by sophisticated risk models and hedges like credit default swaps.
These were the dominating root causes of this pervasive panic. So we know the Dow was overpriced at 14,000, but do we really think that 9,000 or so properly reflects the value of the stock market now?
I don't think so
The market has been beaten down by several factors:
- Subprime correction (see above)
- High oil prices
- Cost of stabilizing the global financial network
- Massive crisis of confidence
Oil prices are already back below $100 per barrel. Moreover, there is more intensity than ever around developing more sources of energy.
The cost of stabilizing the global financial network is huge, but it's a one-time event. Ultimately, it will not factor significantly into stock market valuations, which arise from the aggregated estimations of future growth and the application of P/E multiples (among other future-oriented approaches).
We are keenly aware of the long-term progress of free-market capitalism, not only in the United States, but increasingly globally. We see that governments around the world are not only taking their own measures, but also cooperating to confront the brutal reality wreaked by subprime abuses. We know that in the long run, our equity markets will prevail -- as they have time and again.
Confidence differentiates Fools from the crowd. Consumer confidence is understandably low; it bottomed out around 50 (100 is normal), the lowest since the early 1990s. However, confidence is a lagging indicator, while the stock market is a leading indicator -- more simply, consumers typically look backward, while investors look forward.
Fools, look forward
None of us can quantify the exact contributions of each of these factors in driving down the market. However, we are aware that the subprime correction is only part of it. As for the rest -- well, like I said, it'll pass.
The credit crisis will be resolved. The intensity behind alternative energy will mitigate geopolitical risk and the volatility associated with oil prices. The P/E multiples of countless blue chip non-financial companies are hovering around Buffett’s Magic Number. Now may really be the time to buy.
The market is significantly undervalued because it is unstable and underconfident. This is an awesome time to be picking your spots as an investor, and The Motley Fool is here to help.
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