Markets make fools of us all – sooner or later. Trying to outsmart them, we say things we will later regret.
“We will not have any more crashes in our time,” wrote the world’s foremost economist, John Maynard Keynes, in 1927.
“This crash is not going to have much effect on business,” wrote Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago two years later.
They might have been right. But, then, who would have remembered?
James K. Glassman found a memorable title for his 1999 book, “Dow 36,000.” Now, he tells us that the book “was not so much a prediction as an explanation of how stocks should be priced – and whether for the long term, they are undervalued or overvalued.”
If stocks were undervalued in 1999 imagine how much more undervalued they are now. We appreciate the earnest optimism that Glassman brings to stock-market guessing. He believes you can run a few numbers through your calculator and figure out where stocks ought to be priced. And now, even though the Dow is more than 28,000 points below his target and headed in the opposite direction, he thinks we might still be interested in how he thinks stocks should be valued.
Glassman refers readers of his International Herald Tribune column to a formula on Ed Yardeni’s website that “allows you to plug in estimates of S&P earnings and interest rates. Based on consensus earning projections, Yardeni on Sept. 25 found the market undervalued by 45%.”
A 45% increase does not get you anywhere near to 36,000, but even the longest journey, as the Chinese say, must begin with a single step.
Instead, Yardeni and Glassman stumble. Their formula is based on the ‘Fed Model,’ it turns out, which compares the yield on 10-year treasury notes to with the earnings yield (for the year ahead) on the S&P 500. The consensus earnings estimates put the yield on the S&P 500 way out in front of the yield on a 10-year T-bond, so when Glassman punches the numbers into the Fed model formula he gets a little giddy. According to these numbers stocks are more undervalued than at any time since 1979! Maybe even before ’79 – his chart goes back no further. For all we know stocks may be more undervalued than at any time in the history of mankind.
“I would never try to bully or cajole any fearful investor into the market,” writes Glassman, “But history and reason are firmly on the side of stocks for the long run. ”
“History shows that this could be just the right time to reconsider stocks,” says his headline.
A man who argues that he has God or History on his side should look around him. God and History will decide for themselves, and often end up on the other team.
We don’t know, of course. Maybe Glassman has guessed right about the direction of stock prices. All we know is that the Fed Model is absurd. First, the ‘consensus’ for earnings is the same confederacy of dunces that saw neither recession nor bear market coming…and now says it has been struck dumb by this ‘baffling economy’ and cannot find words to describe it.
We offered a few simple words last week…this week, we add a familiar observation: that when what goes up comes down it comes down to about where it was when it went up.
Even if they got their numbers right, the idea that stock prices are determined by the bond yields is, as Andrew Smithers put it, “supreme nonsense.”
When the yield on the 10-year note goes down, says the formula, stocks are worth more. But what makes treasury yields go down? Well, the Fed can drag them down. Or the market can push them down. In neither case is it necessarily a good omen for corporate earnings or stock prices.
Imagine that the Fed could drag rates down further… desperately trying to avoid a deflationary “liquidity trap.” Imagine that it has the same effect as Japan’s zero rate strategy. Now, try to imagine how this would make stocks more valuable. You might just as well imagine putting Tom Daschle at the head of GE; the stock price would be no more likely to go up.
Or, imagine rates falling further of their own weight. When business goes bad and consumers feel threatened, they typically stop borrowing, cut costs and begin saving. We have no formula to prove this point; it is just something we’ve noticed. As people stop expecting to get something for nothing, the demand for nothing goes down…and with it, the price of credit. The economy goes into a slump, interest rates fall, and yields drop. According to the Fed model, stocks should be suddenly more valuable. But then, according to Glassman, the Dow should be at 36,000 too…
In a boom, falling rates give stocks a boost. People are eager to borrow, spend and invest. Lower rates make it easier to do so. But in a real bust, you can lower rates all you want. It is like offering a box of chocolates to your mistress, after commenting that she might need to lose weight; it’s too late. The damage has already been done. It is time for regrets.
If what goes up later comes down to where it began, investors who stick with stocks will have many more regrets before the bottom is reached. In 1982, when the great bull market began, the idea that stocks might go to 36,000 was even more preposterous than it is now. The Dow was under 1,000 and traded at only 8 times earnings.
No matter what the Fed model says, eight times earnings today would put the Dow near 3,600.
October 7, 2002
Once again we turn to the voice of experience: “every bear market is made up of two or more downward legs and at least one secondary reaction,” writes Harry Schultz.
Uncle Harry, who began covering the markets in his aptly-titled “The Harry Schultz Letter” nearly half a century ago, has lived through more than one serious bear market. He describes a “secondary reaction” – what we might call a bear market rally – as a chance for those who missed the early warning signs to “bail out” and keep their capital intact.
As Eric points out below, the Dow closed out last week at a five-year low…so its seems only pertinent to ask on this cheery Monday morning: was the August 22nd high of 9,053 the last of “secondary reactions” we’re going to see in this bear market? The last chance for investors-in-denial to “bail out”?
“Some bear markets,” Uncle Harry continues, “like the one we saw in 1987, were confined to the minimum – two down legs and one healthy ‘secondary reaction’. Others such as the bear markets of 1968 and 1973 had a number of down legs and secondary reactions. The great 1929-32 affair was made up of no fewer than eight distinct down legs and seven secondaries, a series not matched before or since.”
Well… we’re not certain the bottom is in yet. Nor are we sure we’ll recognize “it” when that day arrives. But maybe… just maybe… this bear market will give the “1929-32 affair” a run for its money.
0ne thing is certain: the markets for the past few months have been vibrating with such volatility they’d make a fighter pilot lose his lunch. An article in USA Today over the weekend points out that between Memorial Day and Labor day, anno dominus 2002, the Dow saw 39 trading sessions with a 200 point swing one way or the other… that’s a full 57% of the total trading sessions. Compare that with just 11 two-hundred point swings during the same period in 2001 and 4 in the year 2000… throw in the fact that during the summer, the Dow also logged its second and third-best all-time point gains… and you can see that investors are speculating wildly in desperation. The second biggest – a whopping 488 gainer – came on July 24th, one day after this year’s previous low…
Whatever happens from here on out, we Daily Reckoners suspect you haven’t seen the last of these wild secondary reactions. What else would you expect, really, as the market twists, sweats and groans through the death throes of the largest speculative bout in investment history…but even more spectacular gasping, twisting and groaning? We suggest using these potential swings to get your behind to safety.
The Daily Reckoning
p.s. Rather than simply give in to the bear, some readers have enjoyed the challenge of trying to “play” these wild swings in the market with options. As I suggested on Saturday, one relatively simple way to see if you can stomach the risk of options trading yourself is to read this special offer from Steve Sarnoff, editor of Options Hotline…
Turbulent Market Ripe For Options Profits
p.p.s. Bill was in the office on Saturday in advance of a sojourn to Madrid, preparing both today’s essay and a few comments, which you’ll find below… but first let’s check in with Eric in New York City…
Eric Fry, from the Street…
– “Bubble, bubble toil and trouble”…another ill-fated week for the stock market. The Dow fell 173 points during the week to 7,528 – its lowest close in five years. The Nasdaq tumbled 4.9% to 1,140 – its lowest level in more than six years!
– How could this be? Abby Joseph Cohen told us that this would not happen.
– But now that it has happened exactly like she did NOT expect, Abby feels confident that the worst is behind us and that folks ought to be buying stocks.
– Fred Hickey, the correctly bearish editor of High Tech Strategist, sees things a little differently. He figures the Nasdaq Composite will continue sliding until it lands somewhere around 600 or 700. The earnings just aren’t sufficient to justify current prices, says Hickey.
– Addison Wiggin makes the identical point in the Weekend Edition of the Daily Reckoning: “If you look at the market through the simple lens of price to earnings,” says Addison, “we’ve probably got a long way to go before this bear market reaches its nadir. At the current level of 800, roughly 30 times earnings, the S&P 500 will have to fall under 500 – an additional drop of about 37.5% just to reach an ‘overvalued’ P/E of 20.”
– Hickey cites Intel as a prototypical example of the market’s overvaluation. Despite Intel’s complete lack of earnings growth, the stock is trading for about 30 times earnings. “Even in the big growth years,” he says, “from 1988 to 1996, big PC growth years, the P/E was as low as 10.7, with a high of 14.2.”
– The stock market is well on its way to a third straight losing year, which means that Wall Street strategists are well on their way to completing three straight years of devastatingly misguided forecasts.
– Like the French and German commanders at the bloody Battle of Verdun, the Wall Street strategists – standing well behind the front lines of course – urged wave after wave of investors to charge into a perilous stock market. The ensuing slaughter of innocents has been unnerving to watch. And the worst part is that the slaughter may not be complete. Merrill Lynch’s chief strategist, Richard Bernstein, for example, provides one very compelling reason why the stock market sell off may continue for a while: the Wall Street strategists are STILL bullish.
– Berstein’s “Sell-Side Indicator” shot up to its highest reading of the past 10 months.
– The indicator is based on Wall Street strategists’ recommended asset allocations. In other words, the greater the strategists’ enthusiastic for equities, the worse the market is likely to behave. The indicator’s current reading of 69.9% is the sixth highest on record. As Bernstein observes: “Wall Street strategists continue to believe that the current environment represents one of the best times to buy equities in the last 16 to 17 years.”
– Responding to the bullish readings of Bernstein’s indicator, Alan Abelson writes, “Ask us not, then, why we’re still bearish. Ask, rather, why are all those people still bullish?”
– Good question.
– Dresdner Kleinwort Wasserstein predicts that the market sell off of the last few months will put a huge dent in consumer spending. “The potential negative wealth effect of stock market losses on consumer spending has gotten markedly worse in a short space of time,” the brokerage firm observes. “At the beginning of April this year, the total capitalization of the US stock markets was about $14.8 trillion, slightly more than the $14.6 trillion average for all of 2001. So, although equity wealth was down from its peak in 2000, it appeared to have stabilized and was no longer doing significant damage to household net worth…However, all that changed over the last four months as stock market averages went into a deep and protracted decline. The broad Wilshire 5000 stock index is now down 20% since the start of this year…[Therefore], consumer spending could fall about $80 billion this year compared to what it would have been otherwise.”
– $80 billion is a lot of spending…we might notice its absence.
Back in Paris…
*** Bill writes on a bright, sunny Saturday morning: “This little corner of Paris where the Daily Reckoning makes its headquarters is a delight. There is always something absurd going on.
A man across the street, on the 4th floor, is washing his windows. As he wipes off the dirty suds, he flings the suds into the street. Passers-by look up and can’t figure out where the water is coming from; it doesn’t look like rain.
Across a few windows down, a pretty young woman has her window open and walks around in her underwear. Hmmm…those ‘dental floss’ underpants… hmmm….
And down on the street, one of the geriatric prostitutes paces in her black raincoat and boots while a drum band makes its way across the street.
And what’s this…a group of vegetarians has begun to demonstrate. “Love Animals” they chant.
How can your editor keep his mind on his work!”
*** “I love animals,” said a friend at lunch, “with a good wine sauce.”
*** A Daily Reckoning reader writes: “In light of [your editor’s] comments that people will get what they deserve, I whole heartedly agree. The idea that actions do not have consequences is so pervasive in our society that most are going to be blind-sided by their effects. “I recently graduated from college and am working my first post-school job. I live in California, have 4 children and my wife is a homemaker. I make $27,600 per year. By national standards, I am in deep poverty. Yet… “We bought our dainty little 3 bedroom cottage one year ago where the mortgage eats up only 30% of my income.
“We pay 10% of our gross to tithes. Both of our cars are paid off… My school loan is paid off… We don’t need a cell phone… We don’t need cable or satellite… We don’t need Nintendo’s or CD’s or Playstations… “All we need is food, books and one another’s company. So on this meager income with a family of 6 in California we are doing just fine. In fact, we are able to put a little away every month and also add to my company 401K plan.
“Personal finance is ever so simple, SPEND LESS THAN YOU MAKE! In the marketplace of life, discipline is key. It is the discipline that states: I don’t need this, I don’t need that, etc. It is the discipline of prosperity!”