Bear Markets for Dummies
People are not what we would like them to be. They are what they are.
– Sylvie, my French teacher
Why do bear markets exist?
Because people make mistakes.
Why do people make mistakes?
Because they are people.
People do dumb things. They pay more for stocks than they are worth. They make investments that can’t possibly pay off. They go into debt, buying things they can’t quite afford. What’s more, they tend to do dumb things together.
All together, egging each other on like 14-year-olds raiding a liquor cabinet, they do things they might later regret.
Will they, one day, stop doing dumb things? We don’t know. But, even with decent odds, dear reader, we wouldn’t want to place money on it.
Arthur Laffer, Lawrence Kudlow and the supply-siders have a different view. With the right policies in place, they believe, a bull market becomes eternal. (Even if that were so, it still presumes that policy makers wouldn’t find a way to mess things up. Politicians and central bankers, we would guess, are at least as prone to error as anyone else.)
Not for 60 years have stock prices ever gone down 3 years in a row, say the bulls. The U.S. economy is the most flexible and dynamic in the world, they remark. Betting against America, Inc. is always a losing proposition, they observe.
Besides, Republican administrations are good for business and good for the stock market. And is this not just like 1982…when the Reagan Administration replaced the Carter Administration?
"I suspect that a big factor in the premature declarations of victory was a false analogy between George W. Bush and Ronald Reagan," writes Paul Krugman in the New York Times, "which led people to expect that 2002 would play like 1983."
"At a superficial level, there are strong parallels between the second year of the first Reagan administration and the first year of the second Bush administration," he continues. "Both men pushed through large tax cuts and big military buildups; both inveighed against evil (empire, axis, whatever). And in 1982, as in 2001, the Fed reversed a previous policy of raising interest rates to fight inflation, cutting rates dramatically to fight recession instead. So why shouldn’t it be morning in America all over again?"
We will answer the question. It is not morning in America because it is evening. There is no bull market, because there is a bear market. It is not 1982 because it is 2002.
Readers who find this an unsatisfying explanation are reminded that it is not the team here at the Daily Reckoning who set the planets in motion around the sun and created man – such as he is – out of the dust of the earth. Morning, we note, often looks a lot like evening – if you face the wrong way at the right time. But it is the opposite end of the day’s cycle.
In 1982, interest rates were high and stock prices were low. In 1982, there were few people who wanted to buy stocks, and many who didn’t. In 1982, America, Inc. looked like a has-been economy. Its currency was widely considered wallpaper-in-the-making and its bonds were described as "certificates of guaranteed confiscation." You could buy the nearly entire Dow for just one ounce of gold.
The trend of the time, in 1982, was down. Then, as now, smart people considered it eternal. Business Week proclaimed that equities were not just in a cyclical downturn…not just sick, but dead.
"Perhaps the most striking difference between the Reagan recession and the Bush recession involves housing," Krugman writes. "In 1982, thanks to several years of very high interest rates, home building was moribund: real residential investment was at a 13-year low, more than 40 percent below its previous peak. So there was a lot of demand ready to roll as soon as interest rates fell. In fact, during the first year of the Reagan recovery residential investment rose 46 percent. Basically, it was a housing-led boom."
As the sun rose in the summer of 1982, it shone upon a wall of worry so high that only a knuckle-headed contrarian would think of climbing it. Every headline seemed to give another reason the bear market would last forever. Every poll showed consumers expected it. Every price seemed to confirm the everlasting trend; the sun had set forever…
And yet, at that very moment, had an investor turned around…he would have noticed a brightening in the sky. Over the next 18 years, the sun rose higher and higher – – to the point where investors were so encouraged by the favorable growing conditions that they scattered their seed like confetti at a parade. Did anyone doubt that it would take root in the hard concrete of lower Manhattan’s financial hothouse or the thin soils of the technology sector?
The year 2002 seems to be everything the year 1982 was not. Today, there are many people who want to buy stocks and few who don’t. Interest rates are as low as they’ve been in half a century and stocks are as high as they’ve ever been. Consumers – who were relatively reluctant to spend in ’82 – pick their own pockets today. The latest figures – from April – show consumer spending increasing at 5 times the increase in wages and salaries. And housing is booming.
Can these sunny trends continue forever? They never have before. And no theory of economics explains how they might. Instead, the typical pattern is for night to follow day. It is also typical for the dumb things people did when they were feeling flush to be corrected – by recession and bear markets.
"There is, however, one more wild card," continues Krugman, "which is also a key contrast with the Reagan years: the attitude of foreign investors. During the Reagan recovery overseas investors, who had previously been down on America, flocked in. This time we start from a very different position. Foreigners have been wildly enthusiastic about America for years – an attitude we have come to count on, because we need $1.2 billion in capital inflows every day to cover our foreign-trade deficit. What happens as they lose their enthusiasm?"
"One of the largely unreported stories of the last few months – in the U.S. media, anyway – is the precipitous decline of foreign confidence in American leadership and institutions. Enron, aggressive accounting, budget deficits, steel tariffs, the farm bill, F.B.I. bungling – all of it adds up, in European minds in particular, to what Barton Biggs of Morgan Stanley calls a ‘fall from grace.’ Foreign purchases of U.S. stocks, foreign acquisitions of U.S. companies, are way off."
When the sun sets, America, Inc. gets marked down. That’s just the way bear markets work.
May 30, 2002 — Baltimore, Maryland
P.S. Here at the Daily Reckoning, we are often accused of being "gloomy." But we are only gloomy when so many others are optimistic – that is, at the end of a bull market. And if it seems as though we look forward to crashes and bear markets…it is only because they tend to cheer us up, for they mean a sunrise is on the way.
Just another DDGU day…
The paper money went down; the real stuff went up.
"I think we are at a turning point for the dollar, and we are looking for an extended period when the dollar will be declining in value against other currencies," David Wyss, chief economist at Standard & Poor’s Co. in New York, said Wednesday.
What worries us is that everyone seems to think so. It takes so little thinking to realize that the dollar should fall…almost everyone who thinks about it arrives at the same conclusion.
A European investor can get 100 basis points more from a 2-year German note than he can from a U.S. dollar equivalent. And he can get 160 basis points more from a UK 2-year note.
Meanwhile, the dollar falls most every day – arriving yesterday at a 17-mo. low against the European competition, the euro. Plus, U.S. stocks – one of ten of which are owned by foreigners – have been going down for the last 3 years, while every one of the major foreign markets is outperforming Wall Street.
If everyone thinks the dollar will fall…who’s left to take the other side of the trade?
Fortunately, most people don’t seem to think at all. And then, there are people like Arthur Laffer. Writing in the Wall Street Journal a few days ago, in a piece entitled "Keep the Dollar Strong," Laffer revealed a mind remarkably uncluttered by economic history or higher reasoning.
"Higher returns abroad and lower returns in the U.S. mean reduced U.S. capital inflows, lower U.S. trade deficits, and, yes, a weaker dollar," he concedes. But, "If the U.S. wishes to maintain our leadership role in the world economy, we’ve got to proceed undaunted in our pro-growth agenda. Just talking about a strong dollar won’t cut it. In the words of Nobel Prize-winning economist Robert Mundell, we need tight money and tax cuts – and then we’ll have prosperity, asset appreciation, employment growth, and a strong dollar."
How the U.S. economy could survive tight money without a major recession, he doesn’t say. But hey, hey…forget the markets. Forget the housing bubble, the debt, the deficits, the profits that aren’t there…the bad investments…the high P/Es…all we need is the proper policies! Let’s vote on it.
Suggestion: Art, read our "Bear Markets for Dummies," below…
In the meantime…Eric, how’s the bear market coming along?
Eric Fry, our man on the Street:
– "Bad things happen in a leveraged, equity-soaked financial system," Barton Biggs said recently. And one of the "most bad" things happening right now is that the stock market keeps falling.
– Yesterday, the Dow slipped another 59 points to 9,923, while the Nasdaq fell 28 points to 1,624. But as the stock market struggled, the gold market sizzled. The yellow metal added $1.40 to $325.50 per ounce…Will this star performer ever slip backstage to its trailer and take a breather…if only to rest up for the next performance?
– John Myers, editor of the RTA, is expecting exactly that – a brief selloff that sets up the next rally. For what it’s worth, the "smart money" is on John’s side. As he pointed out to his subscribers yesterday, "According to the latest Commitment of Traders report issued by the Commodity Futures Trading Commission (CFTC), Commercial Traders are accumulating a massive net short position of 98,504 contracts. Overall, it’s not a good idea to bet against these insiders." Despite his short-term caution, John remains an avid long-term gold bull.
– As we noted recently in the Daily Reckoning, Standard & Poor’s has concocted something it calls "core earnings." This new creation looks an awful lot like the thing formerly known simply as "earnings." In order to calculate core earnings, S&P includes the cost of dispensing stock options to employees and excludes the windfall "profits" that derive from pension fund accounting. Not surprisingly, core earnings tend to be much lower than the "pro forma" variety favored by Wall Street.
– S&P’s intent is to produce a number that, as much as possible, reflects a company’s actual operating profitability. Sounds like a good idea to us…but S&P’s new concoction has struck a nerve with some of the folks in the corner offices. First of all, many corporate executives like their lavish stock option grants, and they don’t like having these obscene entitlements exposed for what they really are – a kind of theft.
– Apparently, Bill, not all of the world’s pickpockets dress like gypsies and hang around in the Paris metro. Some wear hand-tailored suits to work and hang out at the country club on the weekends. Because conventional GAAP accounting doesn’t include option grants as an expense, option programs can be used to pick the pocket of common shareholders without them ever knowing it. But the costs are very real. Maybe that’s why Warren Buffett’s partner, Charlie Munger, calls executive stock options "demented" and "immoral."
– Dispensing options to executives and other employees can be an extremely expensive practice. Just how expensive depends, of course, upon the company in question. Dresdner Kleinwort Wasserstein has just published a report listing the 100 stocks in the S&P 500 whose earnings benefit most from ignoring the cost of employee options.
– "In each case," observes Philip Coggan of the Financial Times, "the improvement is more than 20%. The ten companies where the difference is greatest are: Apple, Sprint, Parametric Technology, Gap, Yahoo, Walt Disney, Mercury Interactive, Network Appliance, Rational Software and Agilent Technologies."
– (Interestingly, for reasons that have nothing to do with stock options, two of these stocks are current short sale recommendations of Apogee Research, a company for which I also toil. Maybe there’s a heretofore- undiscovered link between costly employee option programs and other corporate shortcomings!)
– "The second contentious change proposed by S&P," says Coggan, "is to exclude any pension gains from core earnings. These occur when the investment return on a defined benefit pension plan exceeds the increase in the fund’s liabilities over a given year."
– Milliman, a Seattle actuarial firm, calculates that the 50 biggest U.S. pension funds took a hit to their aggregate portfolio values last year of $36 billion. Yet, thanks to their generous assumptions of how much their investments SHOULD return, the 50 were able to book a "hypothetical" pension fund gain of $55 billion in reported earnings. "The spread between reality and accounting was a cool $91 billion," says Alan Abelson, "and it wasn’t tilted in favor of reality."
– So if you start deducting some option costs here, and start ignoring some pension-accounting gains there, before you know it, honest-to-goodness operating earnings start to look as emaciated as a UNICEF poster child.
– Based on S&P’s core earnings calculation, the S&P 500 sells for about 40 times earnings. If Wall Street analysts were forced to use these numbers, says Coggan, "it would take the courtroom powers of Perry Mason to argue the case for U.S. equities."
Back in Baltimore…
*** Housing prices are booming in many parts of the country. Is your home overpriced yet? "As a good rule of thumb," writes Steve Suggerud, "net rents in real estate (by ‘net,’ I mean after expenses) have averaged about 1% above Treasury bonds (that’s the way it’s been with real estate stocks since 1990). The Treasury bond is at 5.15% as I write, so we might guess that the nationwide average net rent is 6.15%. (6.15% is the ‘earnings-to- price’ ratio, so we need to find the inverse of it for the P/E of your house.)
"If that ‘1% above Treasuries’ rule is correct, that means the ‘fair’ value for a home now, based on net rental earnings, should be a Price-to-earnings ratio of 16…
"According to the June 10, 2002 issue of Forbes, Boston real estate sells for 38 times net rental earnings. And San Francisco is around 30 times earnings. These markets make New York, at a P/E of 20, look downright cheap. Chicago, at a P/E of 17, looks cheap compared to the majors. Just like stocks, as you might imagine, real estate values vary widely.
"I found that you NEVER make money in stocks over the long run when the P/E of the market is above 17.
"While I don’t have the data on homes, the number may be very similar. So if you live in Boston, or Silicon Valley, now may be a time to get out close to the top."
*** If you’re coming to Europe this summer, watch out. "Yesterday friends visiting here from the U.S. were pick pocketed on the Rue Lafayette," writes a friend from Paris. "In fact I was kind of surprised they weren’t hit the first day they were here. They were hit the second day. Last time I was in the Gare du Nord thieves were literally crawling over each other to get to the marks. Here in Paris pickpockets are so common you can take it for granted: if you meet the criteria you WILL be pick pocketed. The criteria: over 40, in couples or larger groups, English speaking, in the tourist areas, etc.
"So the best bet is just to bring several credit cards and leave all but one of them in the hotel. Also in the hotel, leave a list of all credit card numbers and phone numbers for collect calls. Then as the credit cards are stolen, in the course of your visit, you simply call the credit card company, report the theft, and move on to the next card. And so on throughout the visit. And of course you come in and return to the airport with passports and plane tickets in money belts UNDER your clothes.
"You probably won’t have any trouble with your luggage coming in from the airport. I’ve never heard of luggage being stolen. It seems they only want what’s in your pockets and fanny pack, money and credit cards."
*** "What’s that smell?" I asked one evening last week. The apartment stank as if someone had uncapped the central Paris sewer system in our living room.
"It’s the cheese man," Elizabeth explained. "I mean, it’s a cheese that he gave me. It smells so bad that when I opened it, people in the adjoining apartment building passed out."
"The cheese man is unbelievable," my wife continued. "He keeps making advances. He called me ‘his little sweetheart’…and caressed my hand…I thought I should be shocked and indignant, but I wanted to laugh at him. He is so ridiculous."
"Just promise me you won’t run off with the cheese man," said her husband. "It would be so humiliating. I camembert it."