Looking for the Bottom
John Maynard Keynes famously warned that “the markets can remain irrational longer than you can remain solvent.” Considering the recent volatility in stocks worldwide, irrationality appears to be the order of the day. Rarely have investors been so prone to bouts of panic selling, punctuated by spasms of equally frenzied buying. The Dow Jones Industrial Average index lost nearly a quarter of its value between Oct. 1 and Oct. 27, including an epic 700-point drop on Oct. 15. The carnage was followed on Oct. 28 by a 900-point rise, the second largest points gain on record.
These wild swings are unsettling. But against the backdrop of virtually unprecedented uncertainty and complexity that surrounds the meltdown of the global financial system, they are not necessarily irrational. They mimic the mind-set of investors who are cycling between greed and fear as they try to assess whether financial stability is returning, and whether the market has reached bottom after a long and costly plunge. Investors are trying to judge whether stocks have indeed become cheap, as some gurus including Warren Buffett have recently argued.
In times such as these, the rational thing to do is to ignore the front-page buzz and listen to what history and the numbers are saying: the odds are that stocks have further to fall, possibly much further. Short-term relief rallies, based on rays of hope that the worst of the credit crunch is behind us, are head fakes, and proof is easy to find. For example, in July, following the legislation to bail out the mortgage giants Fannie Mae and Freddie Mac, the markets rallied for four weeks, only to head south again as investors began to realize that the world (not just the U.S.) was probably entering a recession.
That’s where the focus of investors ought to be: not on bailouts or the economic stimulus package du jour, but on the economy itself. All over the world, indicators are flashing red. American consumer confidence and spending have plunged. China’s Guangdong province, the boiler room of the global expansion earlier this decade, recently reported its economy in the first nine months of 2008 grew at the slowest pace in 15 years. Most of the G-7 economies have already experienced one quarter of negative growth and will likely experience a recession. Small emerging economies are under serious strain as they seek International Monetary Fund bailouts.
There’s no question that hard times are ahead. What is harder to determine is how much further stock prices must fall before recession is fully priced into shares, taking into account weakening corporate earnings. In past severe downturns, when the U.S. economy contracted by 2.5% or more, the average price-to-earnings (P/E) ratio of S&P 500 index stocks has dipped to as low as 10 (the long-term average P/E is 21). From where we stand today, stocks must drop quite a bit more before they reach this historical nadir. How far? Based on 2008 corporate-earnings estimates, the average P/E for the S&P 500 index is currently about 17. Factor in earnings estimates for 2009 — S&P analysts are forecasting average per-share earnings will be $48.52 next year, down from about $55 in 2008 — and stocks would have to drop at least another 30% before they would start to approach the lows of fierce bear markets of the past.
No one knows how long the slump will last or how it will play out. There are plenty of analogies to describe the possible shape of the U.S. downturn if you plotted GDP growth on a graph: V (short and shallow); W (double dip with a positive blip in the middle as a result of fiscal stimulus programs); L (a protracted, Japan-like stagnation); saucer (stagnation with a very weak recovery). A V-shaped recession now seems highly unlikely. The U.S. housing sector continues to deteriorate, eroding consumer confidence and wealth. Private investment is in free fall, and personal consumption (which accounts for 70% of U.S. GDP) is getting weaker and weaker.
This dark outlook augurs a U-shaped recession. The downturn, which began in the fourth quarter of 2007, will be longer than the usual 18 months. The recovery will probably be anemic and for the next few years the U.S. economy is likely to grow below potential. That’s the best-case scenario. It suggests that we are many months, and perhaps thousands of Dow index points, from a market bottom.
Originally published at Time and reproduced here with the author’s permission.Enter your email address:
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No Responses to “Looking for the Bottom”
Guest • November 16th, 2008 at 6:42 am
If S&P earnings fall from $55 to $48.52 (11.8%) and the S&P P/E falls from 17 to 10 (41%) S&P prices will fall to .882 x .59 = .52 of what they are now, or .52 x 873 = 454.
give me a lever • November 16th, 2008 at 11:23 am
What is interesting and something I’m not entirely sure can be computed is the cyclical nature of this. As prices and stock values fall more layoffs occur as future confindence wanes. As that wanes, spending contracts etc. etc., restoration of confidence is going to be the first step to a recovery in the system, not prices/valuations.I think the bottom will set in when the unemployment numbers cease to rise, as it will indicate most large companies have arrived at a bare bones approach of running their businesses. The increased level of efficently run businesses would also be an indicator of better run companies maximizing their expenses relative to their profits and future earnings (those that will weather this storm).
Guest • November 16th, 2008 at 11:24 am
sorry I meant “minimizing thier expenses” not maximizing… that would just be silly.
Kitzler • November 16th, 2008 at 12:03 pm
In my humble opinion we are forgetting about the transfer of wealth that is occurring between the haves and oblivion as evidenced by falling home prices and equity values. The world’s net worth is becoming less and less.When it will stop will depend on how hungry we are for the good things in life. Unemployment figures are a myth, when you want something bad enough you take either two jobs or you improvise a business.When that happens, then the world economy has no way to go but up. Sadly in order to do that, we must stop looking at Government Largesse and focus on our personal strengths.
james • November 16th, 2008 at 12:05 pm
I will start to buy around s&p 600
SteveA • November 16th, 2008 at 12:18 pm
Actually, The S&P500 trailing P/E got down to 7 in 1979 and there doesn’t appear to be any reason to think things won’t be as bad this time. Using Menegatti’s $48.52 estimated earnings, that would take the S&P500 to $48.52 x 7 = 340. Worse, the $48.52 earnings are “analyst’s forecasted earnings” and are almost certainly higher than the lowest we’ll reach. As far as finding the bottom goes, wait until the S&P500 goes back above it’s 200DMA. That will be close enough.
Hyper • November 17th, 2008 at 12:13 pm
See US MARKET PEAKS AND TROUGHS OVER PAST 75 YEARS. You can see that the P/E ratio fell below 10 7 times out of 12.Also see some nice S&P historical P/E ratio charts based on both reported earnings and operating earnings;and S&P 500 real-time P/E ratio which also has a handy calculator that lets you see the P/E after discounting earnings by a percentage.As of 2008-11-17 13:09, the S&P 500 index value is 871.8, giving a P/E ratio of 17.74 based on reported earnings estimates for for 2009. If I discount the earnings estimates by 10%, based on the calculator, the P/E ratio becomes 19.71.Both of these numbers feel high whilst entering deep into a recession, so it certainly does feel like there’s more downside to go.
Claude • November 17th, 2008 at 2:23 pm
Using the Dow Jones indexes I find the market close to fair value, near a bottom, and in the buy range.The PE ratios of all the 3 indexes (Industrial, Transports, and Utilities) are close to 10 which I regard as fair value given current interest rates and outlook for inflation which is heading toward 0.It is a valid point that earnings may fall below current estimates. To cover this risk I also compiled the DJIA earnings using not the consensus but the lowest, that is most pessimistic, estimates for individual stocks. For 2009 this low estimate is $700/share versus $840/share for the consensus estimate. Thus, for a 10 PE the Dow could still go down to around 7,000. A compromise by splitting the difference in half would give a downside risk for the DOW of 7,700, only about 250 point below the recent low.
Mario Lemeaux • November 17th, 2008 at 7:14 pm
You can analysis the data to infinitum, and spin it which way you choose, but no one can convince me there is another serial bubble lurking to extricate us from this global financial morass … so therefore, the bottom is many, many years away!!!Most marginally profitable companies will not survive 2009!!
tahutch • November 17th, 2008 at 7:21 pm
It’s obvious from this comment that Kitzler has NO comprehension of how things are in the real world. For example, my question to Kitzler is how many jobs do you have?Forget it. I already know the answer. I’ll ask another. Let’s suppose I work at Wal Mart and have a second job at McDonalds. I’m working 16 hours a day, do I make as much as you do?? I already know that answer, too.Cut the “hungry for the good things in life” crap please. Let’s call a spade a spade, this so-called Government Largesse is for the wealthy not the working class. It’s statistically all too apparent. We have people earning 7 figure plus incomes, who are not only not productive, it’s fair to say they are “negatively” productive. They are literally sucking the life out of our economy.”Sadly” we need to start rewarding people on what they contribute to society – not what they take away.
Guest • November 17th, 2008 at 7:25 pm
Hey Hyper,I wouldn’t get too short. In a few months you’ll be writing that you hadn’t anticipated inflation, or whatever you call adding a trillion dollars to the economy. at that point we will be talking “inflation adjusted returns.”
Guest • November 17th, 2008 at 7:30 pm
so will everybody else, hahahaha!
Anonymous • November 17th, 2008 at 10:57 pm
@MarioI couldn’t agree more. Factors get 30pc now for ‘good’ receivables. This diminishes survival of these entities for sure.
Guest • November 23rd, 2008 at 10:01 am
Well comparing to 2008 EPS seem no reliable metrix. As banks wrote of some 500bn of losses (which they actually didnt have all of them, but the market and Roubini told them they should have). These losses might repeat in 2009. But it is unlikely. The same problem occurred at the market bottom in 2003, when trailing P/E was also high due to mark to market losses on cross holdings etc. Using trailing P/E is therefore highly misleading in these circumstance (which Christian should know. If he doesnt he is talking about something he does not know about. If is does he is manipulative). Better metrics include price/book (at 1.7 the lowest since mid 1980s and far lower than after 2002 and 1991 recessions). Price to nom. GDP (corporate profit to corproate GDP has been meanreverting since 1945) shows the same. Lastly, dividend yield is now near the highest since 1960s – at 3.7% + buy backs, equities are yielding substantially more than bonds (and you get any growth on top). So they are cheap. Could they get cheaper? Sure. But looking at the commentary nobody is thinking that this isnt the Depression mark II, and Nouriel is sounding triumphant. Sounds like bottom to me.
