Issue 42 • September 9, 2009 Action and Reaction as Stocks Enter the WORST Month
So, is this merely a speed bump on the way toward higher levels or will markets make a sharp U-turn from here and give up some of their robust gains? While the timing and magnitude of any significant trend change in financial markets can be very tricky to predict, it’s a good idea to periodically run a “reality check” on the market’s risk-versus-reward profile. This exercise helps you to objectively think about your investment portfolio in terms of potential profit and loss from here on out. In other words, ask yourself this simple question: If I were NOT already invested in the stocks, bonds and mutual funds, etc., that I currently hold, WOULD I be willing to buy them again today? Regular readers of Weiss Advice know that I have taken a cautiously optimistic view of the rally this year with emphasis squarely placed on: “cautiously.”
Indeed stocks have certainly run-up farther than I expected they would in such a short period of time. In fact, this has been the strongest stock market rally since the 1930s, early in the Great Depression.1 This is a telling comparison because the magnitude of last year’s stock market decline was also the worst since 1931. Similarly, the magnitude and duration of the contraction in our economy has also been longer than in ANY recession experienced since the Great Depression.2 Market Action and ReactionIn grade school physics class we’re all taught that for every action, there is an equal and opposite reaction (Newton’s third law), so the robust nature of the market rebound we saw this year perhaps should not be such a surprise, given the magnitude of the decline during 2008. In fact, this rally has been even bigger and longer than any of the false rallies seen during the 1929 to 1932 stock market crash. As of August 25, 2009, the S&P 500 Index had gained nearly 52% from the March 9 low, a period covering just 165 days.3 So perhaps the worst of this secular bear market is over ... perhaps. On the other hand, Americans have also experienced the most epic decline in wealth since the Depression. Measured by the decline in stocks and the plunge in home values, U.S. investors have suffered a collective HIT of $14 trillion to their personal finances.4 Experience has shown that after such a major disruption in the economy as we have witnessed–the deflation of the 1930s OR the inflation of the 1970s–it can take many years to return to a “normal” growth path. Much longer than expected in some cases — just ask investors in Japan who are still waiting to “break even” after 20 long years of deflating stock and real estate prices. That’s not to say that U.S. investors are destined for a lost two decades like Japan, but history has taught us that the process of picking up the pieces takes time. And it’s likely to take longer than the six months that have passed since the March low. Remember, from 1980 to 2000, stocks experienced well above-average gains nearly every year, with a few notable exceptions. From 2000 to 2006, home prices likewise appreciated much faster than normal. Of course, much of this above-normal appreciation was built on unsustainable leverage. Leverage in the banking sector helped fuel “financial innovations” such as asset-backed securities, credit default swaps, and subprime loans which helped feed the above-normal appreciation in these assets. Now the cycle has turned and we’re in a period of de-leveraging for banks, businesses, and consumers alike. In addition to $14 trillion in lost wealth and 7 million lost jobs since the recession began, American consumers have also paid down $110 billion in debt.5 While this consumer de-leveraging may be the fiscally responsible thing to do, it is also enormously deflationary for the economy as a whole. Such a climate may NOT be favorable for a rapid return to growth, or record high corporate profit margins, as investors became used to over the past decade. At 1,025 this morning, the S&P 500 Index is discounting 4% real economic growth over the next 12 months, according to analysis from Gluskin Sheff and Associates. Meanwhile, the corporate bond market, which suffered a severe bear market all its own last year, is priced for only 2% real GDP growth in the coming year.6 Something’s Got to Give!Economic growth greater than 2% is likely to be a positive surprise for the corporate bond market, which could lift bond prices even more. On the other hand, anything LESS than 4% growth is likely to be a VERY negative surprise for the stock market.
Typically, at great secular bear market lows, we experience an extreme “under-shoot” in terms of valuation. Stock prices go from unsustainably high valuations (as was the case for stocks in 2000 and housing in 2006) to unbelievably cheap valuations ... an EQUAL and OPPOSITE reaction ... Newton’s third law at work again. But that didn’t really happen in March, when the S&P hit its low of 666. Stocks dropped to about 13-times average earnings over the past decade, but never reached unbelievably cheap levels as in many bear market bottoms of the past, when stocks frequently sold for single-digit P/Es (See graph above).8 Of course, this doesn’t mean stocks must decline right away to a cheaper valuation, or that they’ll ever get unbelievably cheap this time, but it doesn’t mean they will continue to soar at the current pace either. In fact, it may be a longer and more drawn out process ... some combination of lower or even flat stock prices and slow earnings recovery. Only time will tell. Here are a few historical data points you can plug in to your personal risk-versus-reward equation, to help you see if the market is still attractive at today’s prices.
Meanwhile, other indicators we follow at Weiss Capital Management suggest that “fair value” for the S&P 500 may be more like 850 to 900 ... or DOWN -14% from yesterday’s close.12 Of course, markets rarely trade at exactly “fair value.” Instead, they swing from overvalued to undervalued, like the pendulum in an old grandfather clock — action and reaction. The question is: Which way is the pendulum likely to swing next? Oh, and one final word ... September is historically the WORST of all 12-months of the year for stocks. Based on our risk-versus-reward calculations ... we continue to look for better potential buying opportunities to come ... perhaps at lower levels. Good investing!
1 Gluskin Sheff Economic Commentary, 8/11/09 Disclaimers: 1. Weiss Advice is a publication of Weiss Capital Management, an SEC Registered Investment Adviser. Weiss Research is a separate, but affiliated publishing company. Both entities are owned by Weiss Group, LLC. 2. "Weiss Advice" is published for general information and educational purposes only and should not be construed as a specific recommendation to buy or sell any security. Specific recommendations can only be given to advisory clients of Weiss Capital Management, with the benefit of knowing their financial condition and suitability. Receipt of this publication should not be construed as a solicitation to do business outside the jurisdiction for which the Firm is approved. Currently, Weiss Capital Management offers investment advisory services to individuals maintaining legal residency within the United States. For details, please contact the Firm. View Weiss Capital Management's Privacy Policy. To make sure you don't miss our urgent updates, add Weiss Advice to your address book. Just follow these simple steps. |
Stock markets took a well-deserved rest last week after a rally that has carried the S&P 500 Index more than 50% higher since the March lows.
Since the March low, the price-earnings ratio (P/E) on the S&P 500 has expanded from the mid-teens then ... to about 25-times operating earnings now ... which is NOT cheap by any means.
