When The Chips Are Down
The chips rose again yesterday, but not by much. The Dow moved up just 23 points. So far, the rally has recovered 50% of what was lost. And investors are convinced a new bull market is underway. They have nothing to fear but fear itself, they say to themselves. They see themselves responding heroically to the challenge of recession. If they can overcome their fears and stay fully invested, Federal Reserve chiefs tell them, they will prosper.
“I do believe the September 21 low was ‘the bottom’ for this cycle,” writes Ed Yardeni. “One of the best times to buy stocks is during crises, when panic selling occurs. The crises usually trigger corrective policy responses, which prove the doomsayer wrong. So they present great buying opportunities for bargain hunters.”
A quick look at S&P prices reveals the first flaw in this crystalline insight. Barron’s reports that the S&P, far from being a bargain, is as expensive at it has ever been. Stocks sell for 31 times earnings.
The problem is not on the price side of the street’s famous equation. The “P”s are as full-bodied and rosy- cheeked as the ladies on the rue Lombard. By contrast, the “E”s are as pale and broken down as their customers. Earnings have fallen so much that the P/E ratio of the S&P Industrials has risen to over 37. And stocks in the Dow Jones Transportation index have risen from a P/E of only 9 a year ago to nearly 400 today.
Stocks could rise from here. But neither in experience nor in theory would they find much support.
Here at the Daily Reckoning, we are probably as patriotic as the next guy. We had our turkey for Thanksgiving. We say our prayers at night. And when the chips are down, we hope we’ll have the good sense to know what to do, and the courage to do it.
But, today, in neither the War on Terrorism nor in the Battle of the Bubble, are the chips down. Instead, they are dangerously high. People are as confident as they have ever been, believing that the war will end well and the economy will soon rebound…in 2001, Americans may open their mail with rubber gloves and cross themselves before boarding an airplane, but they take no precautions before buying stocks at 50 and 100 times earnings. On all points, we believe their assessment of the risks is off the mark.
The last time the chips were really down for the U.S – both militarily and economically – was 1941.
“When the American Fleet was attacked at Pearl Harbor on December 7, 1941, the U.S. stock market was at possibly its most depressed level of the 20th century,” writes Marc Faber. Then, stocks were worth about 21% of the entire nation’s GDP. Today, they are worth 5 times as much.
Stocks, measured by the Dow, had hit a high of 381 in 1929. Those who have convinced themselves that the present 50% signals a new bull market may want to recall that after ’29, the market collapsed and then regained 48% of its losses – before beginning the worst bear market in history.
Twelve years after the ’29 crash, the U.S. stock market – like Japan today – was still down about 70% from the high. The Dow stood at slightly over 100 when Pearl Harbor was bombed.
Earnings had collapsed too. Dow stocks were earning $11.60 a share in 1941 – down from the $19.90 recorded in 1929.
What’s more, in December of ’41, the Dow sold at less than book value. The chips had fallen so far that Dow stocks provided a dividend yield above 6% and had an average P/E ratio of just 10. At the time, many observers were worried because the P/E was so high; it had been pushed up by falling earnings!
Bonds, meanwhile, were considered safe. Confidence was so low, and safety so highly prized, that investors were willing to pay three times more for each dollar yielded by a bond compared to that of a stock.
When the Japanese struck at Pearl Harbor, Americans knew that it meant a long war against a real enemy. The Japanese had tanks, artillery, planes, ships, aircraft carriers. They had proven themselves to be determined, resourceful, well organized and disciplined opponents – nothing like the rag-tag band of cutthroats the U.S. faces in Afghanistan.
Immediately following the Japanese attack, the chips fell further. “The Dow’s earnings yield reached more than 10%,” writes Faber, “more than five times higher than the long-term government bond yields.”
The comparison of the bond yields to stocks’ dividend yield shows the difference between a market when the chips are up and one where they are down. Never, before or since 1941, have bonds yielded so much less than stocks. And never, before or since 2001, have stocks yielded so much less than bonds.
By these measures, the chips were never lower than in 1941 and never higher than in 2001.
Of course, 1941 turned out to be a “lifetime buying opportunity” for stocks, says Faber. Stocks rose throughout the ’50s and ’60s. An investor might have even held on through the bear market of the ’70s and still done well – with the Dow rising from 100 to over 11,000 over the entire 60-year period.
Bond buyers, on the other hand, did poorly. They entered a long-term bond bear market that lasted for the next 40 years.
In less than 2 weeks times, we will mark the 60th anniversary of the Pearl Harbor bombings. The chips were down then and not expected to rise anytime soon.
The days following proved, as Mark Faber notes, an excellent time to buy stocks. The chips are up, now, and expected to continue rising. This, we suspect, is an excellent time to sell them.
Your devoted correspondent…
Consumers did their patriotic duty on Friday. “Shoppers mobbed malls,” reports the Chicago Tribune, as Operation Homeland Prosperity continued.
There were a few shirkers, of course. But even the habitually frugal were lured into the Battle of the Bubble with promises of deep discounts and zero interest rates.
And what’s this? Our old “River of No Returns” stock – Amazon.com – rose 35%! How could we be so wrong?
Apparently, even the Internet was mobbed by bargain hunters and investors were so excited they forgot that the New Economy is history.
But as shoppers wore out the carpets, the results were “no sales bonanza,” says the Trib.
One major problem: what the economy really lacks is not sales, but profits. Profits are falling at about a 67% annual rate…”the worse profits carnage in the whole postwar period,” says Dr. Kurt Richebacher. Of course, almost every analyst on Wall Street predicts rising profits next year. But what do they know? Actual earnings have averaged only about half the level of First Call’s estimates so far this year. These experts didn’t see the profit collapse coming and have no idea where it is going.
Without profits, companies do not hire more workers; they do not build new factories or retail outlets; nor do they invest in new computer equipment. They do the opposite – they cut back in order to restore profitability.
That’s what happens in a deflationary downturn, dear reader. And it seems to be happening now. You can’t make profits by giving away your merchandise. All you can do is make sales. And even trying to make up the losses with volume – as Amazon.com has tried to do – is, after all, still a joke.
But the Wall Street cheerleaders are still leading cheers. More from our own “crazed Wall Street cheerleader,” Eric Fry in New York…
Eric Fry writing from Manhattan…
– Lukewarm retail sales over the Thanksgiving holiday failed to take the shine off of the “recovering economy” scenario that bedazzles so many investors.
– The Dow gained 23 points to finish the day just shy of 10,000, while the Nasdaq surged 2% to 1941.
– Foot-traffic in shopping malls over the Thanksgiving weekend was about 8% lighter than last year’s, according to RCT Systems.
– Sales rose a little anyway. But that’s because retailers are resorting to widespread discounting in order to attract all those credit-card-wielding shoppers. Wal-Mart, which posted a single-day sales record of $1.25 billion on Friday, “lured cost-conscious shoppers with $84 19-inch color TV sets and $74 DVD/CD players,” smartmoney.com reports.
– These “loss-leader” promotions – just like zero- percent auto loans – will generate sales for a while. But it’s hard to see how unprofitable sales will pave the road to economic recovery.
– It’s also a little hard to see how anyone could construe my consistently cautious musings of late to be bullish. And yet, it is clear that some folks who contribute to the dailyreckoning.com “discussion boards” mistake me for a bull…Egads! One gentleman, a Mr. Joshua Courtney, labeled me a “crazed Wall Street cheerleader.” Imagine that.
– Allow me to pose a question to all those Mr. Courtneys out there. If I directed a gushing fire hose into a leaky barrel, would the barrel fill up with water? Certainly…for a while. And if the Federal Reserve rains torrential money-supply growth and low short-term interest rates down on our parched economy, couldn’t a few green shoots of economic growth sprout up here and there? Certainly…for a while.
– But a few random clusters of wild buckwheat hardly make for an industrial-strength grain harvest…And nothing less than a bumper crop of economic growth could justify the rich valuations many U.S. stocks now carry. Needless to say, that doesn’t stop Wall Street’s professional bulls from urging folks to continue buying expensive stocks.
– Yesterday, Merrill Lynch strategist Christine Callies boosted her recommended stock allocation to 74%, while setting aside just 1% in cash – presumably for a rainy day. Callies predicts that the S&P 500 will climb another 22% next year. Now that, my friends, is a “crazed Wall Street cheerleader.” I am but a feeble imitation.
– Happily, Mr. Courtney took time out from hurling insults to provide some enlightened commentary about the state of our economy and our financial markets. “The U.S. economy is drowning in excess capacity,” he writes, “whilst at the same time her consumers are utterly tapped out with zilch savings and huge debts. Add in…a bursting housing bubble, a still wildly overpriced stock market, the serious potential for a collapse in the U.S. dollar, the myriad dangers associated with derivatives, and the only place the U.S. is going to be visiting in 2002 is the poor-house.”
– Mr. Courtney was also gracious enough to provide (“for Mr. Fry’s enlightenment”) a missive from the folks at Comstock Partners entitled, “The Illusory Economic Recovery.”
– “We’re surprised that economists and strategists are interpreting the mild economic comeback from the artificially low September numbers as the beginning of an economic recovery,” Comstock writes. “[T]here is no reason to assume that this constitutes the start of a true cyclical recovery.
– “In our view the underlying economy is still deteriorating, and the recession will be deeper and longer than most expect. The highly valued and complacent stock market is looking for a much more optimistic outcome, and is likely to be severely disappointed.” Amen.
– Whether the economy bounces a little or a lot is immaterial. That the bounce, however pronounced, lasts no more than a few weeks or months is the great risk that all of today’s stock-buyers face.
– Does that make me a crazed bull, a crazed bear or merely a crazed chicken?
– Lastly, a hearty Daily Reckoning congratulations to Fed Chief Greenspan for receiving the Enron Prize for Distinguished Public Service in Houston. (Really, this is not a joke).
– We’re not exactly sure how one wins this tremendous honor, but we’re guessing that, in the spirit of Enron itself, the award is given to the “one individual most responsible for helping the economy to track a trajectory like Enron’s stock – a euphoric flight upward, followed by a death spiral.” But that’s just our guess.
Back in Paris…
*** The latest from “Wrong Way” Yardeni: “There is ample financial liquidity. Energy costs are low. Interest rates are low too, and 0% financing has boosted auto sales. The economic recession is likely to remain shallow and should end by next spring. The profits recovery during the second half of 2002 should be robust.”
*** What does he know? Nothing. He’s just guessing – like the rest of us.
*** Meanwhile, the U.S. is now “officially” in recession, reports the International Herald Tribune. And “Bankruptcies R Us”, says the NY POST:
*** “Corporate bankruptcies and debt defaults are rising to record-high levels – and market watchers fear there are many more to come. In the last two weeks alone, as consumer confidence gained ground and stocks rallied, more than 200 companies filed for bankruptcy in the United States, according to BankruptcyData.com. While not all are brand-name, publicly traded firms, many are, including ANC Rental Corp., the company behind Alamo and National car rentals.”
*** My work never seems to end. Last night, I went to see a very “modern” opera at Chatelet. The elegant old theatre was packed with $80 ticket holders. But modern opera must be an acquired taste, like the French cheese that smells like a subway bum. Elizabeth got more out of it than I did. She falls asleep more readily. More details…Thursday.