Broker Check

Market Comment July 02

Belmont Financial

Market Comment


Given the ongoing market turmoil and the stress we are all experiencing, I want to share my responses to some of the more common questions that I have been fielding regarding the recent market downturn.  I trust that you will find this helpful and encourage you to contact me if you have questions.  


How Low Might The Stock Market Go?


In an emotionally driven market there is no way to know for sure. When greed was out of control, the popular stock market averages (e.g. the S&P 500) went far beyond what rational analysis would have forecasted. We must be cognizant of the possibility that the same irrationality can work on the downside.


The trouble is that emotion is not so easy to analyze. And just as there were optimistic analysts who stepped forward to defend even higher stock levels, there are now pessimistic analysts making the case in support of much lower levels. That they are there making the case doesn’t make them right. As for me, I’m more comfortable analyzing economic fundamentals than assessing market psychology. So, in attempting to provide some perspective on this question, my approach is to make historical comparisons of several types of data in order to provide a frame of reference.


Valuations: As of Tuesday July 22nd, a basic valuation model suggests stocks were 53% undervalued. At the end of the last big bear market (1973 and 1974), stocks bottomed at a 55% undervalued level. I also took a look at the Fed’s stock valuation model. It currently shows the stock market as 36% undervalued, exactly where the 73/74 bear ended.


Absolute Decline: The S&P 500 has declined by 47% on a price basis. During the 73/74 bear market the S&P 500 dropped by 48% (but it did have a higher dividend yield). Before that it was the 1930s’ depression period when we last saw declines larger than the decline in the S&P.  As you know the NASDAQ has fared worse and is now down 75%. The last great bubble before the NASDAQ was the Japanese stock market. That market dropped 57% over 30 months (and has remained in a trading range for another ten years and counting.) There are significant differences between the U.S. and the Japanese market, though. While there are concerns about our real estate market, the Japanese real estate market was a massive bubble, and Japanese stocks were even more overvalued than U.S.stocks at the peak. Japan's banking system was and remains sick and the government has not been aggressive in reforming it. The U.S. has a history of being much quicker to "take our medicine" when we need to, as was the case in the S&L crisis.


Length of Decline:  The current bear market started two years and four months ago. That makes it longer than any U.S. bear market since the depression years.


Technical Factors:  I do not rely on technical analysis in my decision-making. However it is true that the end of most bear markets is characterized by large declines on very high trading volume. On Friday, July 19 the market was down big on very high volume and on Monday it was also down on high volume.


How low might the market go? I can’t say for sure but by all the above measures I can argue that this bear should be nearing an end. However, we don’t have many secular-type bear markets to study so it’s hard to pound the table with enthusiasm. Moreover, it’s true that the overvaluation was at a record level suggesting the possibility of an equally strong overreaction on the downside. I can’t say with certainty that stocks won’t decline and become even more undervalued. Nevertheless, valuation levels are now attractive based on several methods.



But Can We Believe The Valuation Measures?


Since interest rates are so low, valuations are deceiving. A few weeks ago, a relatively small blip up in rates would have wiped out the valuation gap. However, after a huge drop in stock prices so far this month that is no longer the case. Even if interest rates rose a full percentage point, at current levels stocks would still be more than 10% below fair value based on relatively conservative assumptions and 25% undervalued based on standard assumptions (as of July 22).


What About Earnings? How Can We Be Confident About Valuations If We Can’t Measure Earnings?


It’s likely that there will be more earnings restatements in the coming months as more companies come clean on aggressive accounting techniques. Despite this expectation we can be fairly confident that current and anticipated earnings will support higher stock prices. There are multiple reasons for this confidence:


Normalized earnings: This measure is based on reported earnings (not pro forma) and looks at average earnings over five years including forecasted earnings for the next 12 months. Valuations based on normalized earnings (a P/E based on normalized earnings is compared to interest rates) are at the cheapest level since 1980.


Trend earnings: The earnings collapse just experienced was the biggest deviation from the trend of long-term earnings growth since the 1930s. Over the years big negative deviations have triggered big positive deviations and most of the time these were sustained for a number of quarters and followed by more quarters of above-average growth. The current earnings level is significantly below where it should be based on the long-term earnings trend. I believe the earnings collapse and expected snapback is a bigger variable than expected restatements.


Profits from current production: This is a measure from the National Income and Profit Accounts (NIPA) taken mostly from corporate tax returns (remember corporations have an incentive to understate, not overstate, income on tax returns). NIPA is not comparable to S&P profits or other similar measures (it includes all corporations rather than just public companies), and it does not always correlate well with the S&P. But the long-term growth rate is similar to the S&P and it has tended to correlate better if compared to S&P profits two years out. Recently NIPA profits have been spiking higher, reaching a record level. In addition, the ratio of S&P profits to NIPA profits is very low, suggesting that S&P profits are unsustainably low compared to the more-reliable NIPA measure. Over the past 15 years this ratio was only lower coming out of the last recession. NIPA profit measures provide encouraging evidence that current S&P profits are overly depressed and likely to rebound.


Real Profit Growth: Over the past 50 years, almost every time real (inflation-adjusted) earnings growth collapsed over a trailing five-year period, very strong real growth followed during the next five years. The only exception was in the inflationary 1970s. The earnings collapse this time was the worst in the 50-year period. Profit growth has usually been very strong coming out of recessions but the period following the 1990 period was an exception.


There Is So Much Bad News Out There—Isn’t It Possible That This Bear Will Be Much Worse Than In 73/74?


This bear market is now within a whisper of surpassing ’73/74 so at this point I’d say there is a good chance it could be worse, at least for the S&P 500. The real worry is whether it will be much worse. Again, I can’t say for sure. But the fact that there is lots of fear based on real problems (economic risks and the terrorism wildcard) doesn’t necessarily foreshadow much more downside. Remember, bear markets end at the point of maximum pessimism, when fear is greatest. And at a bottom it will always feel like the stock market is about to drop another 20%. Doom and gloomers will get lots of exposure in the media. It is around this time that most of the selling will be done so that a small amount of buying can drive stock prices higher.


Remembering 1974 is useful. We had Watergate and Nixon’s resignation, the Middle East oil embargo, surging inflation and recession and a discredited Fed that all combined to create a massive pessimism. A Business Week writer wrote in the 9/14/74 issue ”…the flight of individual investors and the breakdown of the markets foreshadows the end of the capitalistic system as we have known it.” (During the fourth quarter of 1974 the stock market delivered a positive return and the bear was over.)


Certainly it is possible the pummeling could intensify even more. One of the worst-case scenarios I can imagine would involve a reversal in the housing market. But that does not seem to be a high-probability outcome. The banking system is very healthy given where we are in the economic-cycle, loan delinquency rates are not high and corporate profits are recovering. There are always risks of bad things that could result in temporary losses in the stock market. But in bear markets investors tend to see the glass as half empty just as they see it as half full in bull markets.


What About The Accounting Shenanigans?


I believe there will be more bad headlines and many restatements. However, I don’t believe mostcorporate managements are dishonest. And as noted above, though we can’t be sure, I now believe earnings are so depressed that a cyclical rebound (which is already showing up sharply in the NIPA data) is likely to offset earnings restatements. I also think that with politicians and the media focused so heavily on this issue, and with CEOs now having to sign off on financial reports over the next few months, the remaining misdeeds will be quickly exposed. It may be quite awhile before investor confidence in corporate governance begins to rebound and that may delay a return to fully valued multiples. But, I don’t think it will be a barrier to a market rebound when selling pressure subsides.


Does It Matter Where The Bottom Is?


For clients who can’t tolerate any more temporary losses the bottom does matter. However, for long-term investors whose psyche can absorb more short-term damage, I believe stocks are at levels that are very likely to deliver good returns over the next several years and very possibly quite high returns over the next six to 18 months. I can’t say with certainty, but based on my analysis I believe clients who can tolerate more short-term pain should sit tight and they will be rewarded from current levels. For these clients, guessing “where the bottom is” only distracts us from the longer-term opportunity. The risk in getting defensive now is missing out on the upturn. It’s easy to say, “Let’s get out and get back in when the market stabilizes.” The reality is that it is not so easy to know when the market is stabilized. If the market is up 10% in a week, is that the start of a new bull market or a head fake? There is no way to know and most investors who didn’t want to be in the stock market at lower prices will have a very difficult time pulling the trigger to get in at a higher level when many of the headline risks still exist (and they will). The difficulty of the buy-back and my belief in the valuation work (and what it suggests for coming returns) is the reason we don’t raise cash and “wait it out.” But in order to be patient any client must be able to tolerate the economic and psychological impact of more losses in the near term, should they occur.









What Are The Risks To This Analysis?


The primary risk is that the economic recovery is very weak or that it falls back into recession. The declining stock market could contribute to this scenario as it feeds back into the economy. This is a lower-probability scenario but it is not out of the question. The stock market is already discounting some of this as a possibility. But if it happens the upside will be more limited in the foreseeable future and there would be more downside.


What should we take from all this?


When stocks were in a bubble we resisted greed-driven thinking and instead focused on rational analysis of valuations and underlying economic fundamentals. Similarly, we are now resisting fear-driven thinking and focusing on the same rational analysis of valuations and underlying economic fundamentals. If there is one thing that we can say we always believe, it is that this approach pays off in the long-term.


Prepare yourself as best as you can – if we don’t see a turnaround in the next week or so, your July statements are likely to show meaningful declines.


I am sensitive to your fears but want to remind you that when we’re finally at a bottom it will still feel like the worst is yet to come.


We are hopeful that we will see a rebound before the end of the year. The tough thing about setting a loss threshold is that in a devastating market like this one, the point where we get close to our thresholds is also likely to be close to the point at which we reach a bottom.


Final Remarks


I am confident that we will be rewarded for staying the course.  That being said, we may be in for a volatile next few months and we encourage you to call us if you have any questions regarding your portfolio and/or the most recent market outlook.



Mike Durant