Markets Get an 'F' in P/E

Even though the S&P 500 index itself has fallen from about 1,590 a year ago (with a P/E of 18.9) to where the index is actually down by about half, earnings are down by half, too! And we all know what that means for the P/E ratio. It’s no wonder we’re hearing incessant screaming from the Mogambo Bunker Of Doom (MBOD).

"The Next Big Storm to Hit the Markets" is the headline for an essay by John Robson & Andrew Selsby of Full Circle Asset Management, who write, "Above all others, the outlook for corporate earnings is the big issue", and they expect that earnings will "also catch ‘fall off a cliff syndrome’."

Immediately, I think to the Price-to-Earnings ratio of the S&P 500 index, as shown in Barron’s, and sure enough, earnings have been trending down for the entire year, which is, of course, bad news, as is proved when you see that the market value of the S&P 500 is down by about half in the last year, meaning that if you owned the stocks in the S&P 500 for the last year, then you have lost half of your money, and you are probably plenty upset!

So you would think that, you know, the P/E ratio would have fallen, especially since the prices of the stocks in the index (which are the P in the P/E ratio) have fallen by half, and you have lost half your damned money, about which you are still plenty peeved.

But surprise! Even though the S&P 500 index itself has fallen from about 1,590 a year ago (with a P/E of 18.9) to where the index is actually down by about half, earnings are down by half, too!

So this means that although the company made half as much money, and you, the hapless investor, lost half of your money investing in their stocks, both the P and the E went down, and thus the Price-to-Earnings ratio is still at an elevated 19! It’s actually higher! Hahaha!

Anyway, the point is that this current Price-to-Earnings ratio of 19 for the S&P 500 index is so high (audience shouts out, "How high, Mogambo?") that it is still near where, historically, the market soon started down in a huge bear market, and is still high even after losing half its value! Gaaaah! I’m scared!

In fact, you can still have a high P/E of 19, indicating a high price, even if the earnings of the entire S&P 500 fell to a measly 1-cent and the shares in the index sold for a collective 19 cents! Hahaha! It’s weird!

You can tell by their faces that they are aghast that I would be ruining their presentation with my stupidities, and so they immediately get away from P/E ratios altogether, and instead turn to consumption and interest rates, whereupon they write, "consumers have started a spending strike, so any business that sells to them is heading into a huge headwind. This in itself is probably enough to do the damage but there’s more. Credit markets are at worst, closed and at best, much more expensive", which they prove by noting, "Spreads for investment grade corporate bonds are 550 basis points over treasuries; even worse, junk bonds are a huge 20 percentage points above treasuries."

They then cite a statistic that I have never heard of before, perhaps because I am an ignorant and stupid guy, but I was surprised to learn that "Looking forward, companies have no option but to slash capital expenditure, which is to say, slash other companies’ earnings, a vicious spiral that carries with it so much potential consequence that the Markit iTraxx Crossover Index is above 1000 for the first time since it was created, inferring that a record…number of companies are on the verge of default."

Now, naturally I have no idea what in the hell any of this means, but I am always very interested in indicators that are in record territory, and I am willing to believe anything bad after hearing the words "on the verge of default".

Then I remember that I am in gold, and I am calmed. Whew!

Of course, I’ll be ecstatic when gold zooms in price in response to such fiscal and monetary madness, but right now I am calmed. But really looking forward to ecstasy! And at these rates of monetary insanity, it can’t be far away! Whee!

Until next time,

The Mogambo Guru
for The Daily Reckoning
December 15, 2008

Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter – an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron’s, The Daily Reckoning and other fine publications.

The ground is giving way beneath our feet: Sell the dollar…Sell Treasuries.

People still stand their ground…they do not panic. They do the right thing. But then, they go into work – but find they have no jobs. They look at their pension account – wisely invested in a diversified portfolio – and find that it has lost half its value. And their houses lose 20% of their value. In places such as San Diego, Las Vegas and Miami, the losses are more like 30%- 40%.

The ground gives way…and they find themselves in Hell.

Friday, the Dow registered a 61-point improvement, after much disappointment the day before. Is the rally on or off? We don’t know…

But what MUST happen, WILL happen. Fish gotta swim. Birds gotta fly. And bubbles gotta pop. The bubble in private debt has popped already. And now, the bubble in public debt has to pop too. And the dollar’s got to go down. That’s when the ground will really give way… For many people, the collapse of the dollar will wipe out what is left of their assets. Pension funds and insurance companies will be devastated. Savers will be unsaved.

Investors have rushed from risky investments of all sorts – emerging markets, mature markets, real estate, commodities – into the strong, welcoming arms of the U.S. Treasury market. "Give me your tired, your poor huddled masses of dollars…yearning for protection from capitalism," says Uncle Sam. "And I’ll give you 2.58% return over 10 years. Give me your money for 91 days, and I’ll give you nothing."

Is that a good deal, dear reader? It depends on how solid the ground is under the U.S. Treasury market. So far, as the ground gives way under other asset classes, the Treasury market has held solid.

But here is why the word "must" was invented. When something’s gotta happen, it’s gotta happen. The U.S. federal government already has an official national debt over $10 trillion. The deficit for next year will likely exceed $1 trillion…and could reach up to $2 trillion by 2010 – or more than 4 times the biggest deficit the country has ever run…and more than the entire U.S. budget only seven years ago. At this rate, in a couple of years, U.S. debt will exceed US GDP.

Is it likely that the feds can so greatly increase the quantity of U.S. debt without reducing the quality of it? Is it likely that the last IOU issued by the federal government will be as valuable as the first? No, it’s not likely. Something’s gotta give.

And we are talking about big money. A business or a small government can sometimes borrow more than its annual revenues. It’s borrowing can be funded by a small percentage of the world’s reckless savers. Lending to U.S. government on such a scale is another matter. It takes up a large percentage of the world’s total savings, effectively shouldering other borrowers out of the way, and actually reducing the world’s capacity for economic growth.

Everybody, except bankers of course, knows that lending large amounts to a small country is extremely speculative. But lending to the United States for ten years at 2.58% has a nasty stink of certainty about it. You can’t borrow that kind of money without some consequences…and the consequences of that much debt are bound to be bad.

To us, it seems almost inevitable that it will turn out to be a bad place to put your money. Because the ground is almost sure to give way beneath the feet of Treasury-market investors. How so? Ben Bernanke has already told us. When the borrowing gets tough, the Fed will turn to other forms of liquidity – buying U.S. Treasury bonds itself. In other words, instead of borrowing from savers – thus leaving the net money supply unchanged – the Treasury will borrow from the Fed. Where will the Fed get trillions of extra dollars? It will create them out of thin air.

That’s why the dollar has turned down.

"Greenback’s haven status thrown into doubt," reported the Financial Times.

Last week, the euro jumped to $1.33 – a level it hasn’t seen in many months. And gold keeps edging up. It’s up to $820 an ounce as of last week.

The dollar is Hellbound, dear reader. Sell it. And sell Treasuries too. We might be early with this advice. But we won’t be wrong.

*** If you want to own gold coins, you’ll pay $870-$890 an ounce. Coins are scarce. People are looking for something solid to hold onto. Coins are solid. They are portable. They have no hidden liabilities.

And you won’t pick up the paper and find that a crook like Bernard Madoff has stolen away the value of your gold coins. The latest Wall Street desperado took investors for some $50 billion. And now the FBI, SEC and all the gumshoes and hacks are making a big deal of it.

Of course, in purely financial terms it is a big deal. The press has labeled it a "ponzi scheme." But Charles Ponzi took in only $10 million. Peanuts compared Madoff’s scheme.

Another important difference. Ponzi took money from ordinary investors, widows and orphans. But Madoff went for bigger game – hedge funds, banks, and professionals. Today’s news tells us that the world’s largest bank – HSBC – was a victim. Banks in Geneva said they were out $4 billion. The Fairfield Greenwich Group said it had invested $7.5 billion with Madoff.

Of course, we don’t like to see widows and orphans lose get scammed. But hedge funds? Banks? Who can honestly say that they don’t enjoy seeing these mighty moneymen tripping over their own greedy delusions? Here at The Daily Reckoning…the news of Wall Street’s losses cheers us up…like reading the obituaries and finding no mention of our own name.

But when you own a gold coin you won’t have to wonder if the balance sheet is made up…or if the trades were fictitious…or why the SEC was asleep at the switch. A gold coin is what it is…no more, no less.

When the ground gives way…gold coins stay right where they were – or go up in value.

Not that we’re urging you to buy gold coins. We did that for the last eight years. Now, you’re on your own. But we will give you this one tip: you can buy gold for just a penny per ounce.

*** Word from the Washington Post is that autoworkers are "angry." Why should they be angry? They’ve been paid far too much (compared to autoworkers in, say, India) for far too long. Now their gravy train seems to be stalled on a sidling and they want the government to "to something" to get it going again.

It isn’t fair for the feds to bail out Wall Street but not Detroit, they say.

Elsewhere in the news, Bloomberg has asked the Fed to reveal what it did with the $2 trillion in emergency loans it passed out. Surely, the money went to the Fed’s clients – banks, and financial institutions generally. How? To whom? What were the terms? The Fed wouldn’t say. It refused the Freedom of Information Act petition on several grounds.

"Blank check for banks, pink slips for Detroit," is how Gretchen Morgenson explains it in the New York Times.

The UAW has a point, of course. Neither industry should be bailed out. But if you’re going to throw money around in Manhattan, why not toss some to Detroit?

But the autoworkers can stop kvetching. Detroit will get its bailout too. Just wait.

*** And a note from Short Fuse, reporting from Baltimore:

"Last night following the Ravens/Steelers game (ouch! What a game!), 60 Minutes covered what they called, ‘The Second Mortgage Disaster on the Horizon’.

"That’s right. Looks like the mainstream media is finally picking up on something we’ve been covering in these pages for over a year now: Alt-A and option ARMs.

"For those who are new to the game, Alt-A and option ARMs are two other types of exotic mortgages that have been lurking in the background, while the rest of the country worries about subprime alone.

"Although these loans were made to people with higher quality credit, these types of loans, specifically the option ARMs, still lured borrowers in with ‘low teaser rates.’ The problem with these rates, however, is right in the description…they are just a ‘teaser’. Eventually, they reset. And a mortgage that was $800, can shoot up to $1,500…and many homeowners are ill-equipped to deal with this. In fact, one out of every ten homeowners in the United States right now is behind in their mortgage payment.

"Back in September of 2007, Strategic Short Report’s Dan Amoss warned, ‘The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that’s having enough trouble working through a huge supply overhang.’

"And we are nowhere near the end of the pain that will (and is) being felt from the rate resets and subsequent defaults. Whitney Tilson, the fund manager that 60 Minutes interviewed for this story gave viewers this uplifting tidbit:

"’We had the greatest asset bubble in history and now that bubble is bursting. The single biggest piece of the bubble is the U.S. mortgage market and we’re probably about halfway through the unwinding and bursting of the bubble…It may seem like all the carnage out there, we must be almost finished. But there’s still a lot of pain to come in terms of write-downs and losses that have yet to be recognized.’"

All we can tell you, dear reader, is get ready for the long haul. And do your best to stay ahead of the game. Not to toot our own horn, but your dedicated editors, both at The Daily Reckoning and at Agora Financial as a whole, have been diligently warning of this meltdown and the consequences it brings for the global economy for the past few years. And those who heeded this advice have been positioned to profit in a time when most investors are losing their shirts…and there is still time to join the ranks of this group of savvy investors.

We realize how important it is to stay on top of all major market sectors, so we have opened the doors to the Agora Financial Reserve. For a limited time, you can get all of the research and investment services that Agora Financial has to offer – for life.

*** "What Hell Really Is…" said the sign in front of a church in Arizona. "Choir practice at 4 PM!" was the next line.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning