How low can you go?

A lot people are wondering how bad the stock market can get.

I don’t know how low it will go, but I have a pretty good idea of how low it can go.

Before I outline my reasoning, let me forewarn you: the answer is ugly.

I’m not trying to predict what the market will do or when–no one really can. I’m just trying to prepare you for the worst case scenario just in case it happens.

You don’t want to sell at the bottom. Nothing will hose up your long term goals as much as going to cash in hopes you can sell at the top and buy at the bottom. The odds are highly in favor of you doing just the opposite–most people do. Knowing how bad things can get may help you avoid selling at the bottom, and that’s what I’m trying to do in this blog.

The reality is I’ve never been as bullish as I am now. I’m projecting the highest returns going forward I’ve seen in 13 years! I’m terribly excited about the returns I believe I’ll get over the next 5 years. But, and there’s always a but, the stock market could go a lot lower before it goes back up again.

How low? History indicates the market can get as low as 7 times normalized earnings. I’ve talked about normalized earnings in the past, but let me explain it again briefly.

The stock market’s per share earnings have grown quite steadily at around 6% a year over the last 50+ years. In boom times earnings are above this trend, and in bust times earnings are below. But, over time, the earnings always return to trend.

Such earnings are like true north to a navigator. They point the way in all circumstances and provide a ready reference for where you are and where you’re going.

That’s why I use normalized earnings–it’s a steady guide. In boom times, the stock market sells at over 20 times earnings. In bust times, it tends to go down below 10 times earnings. In the worst times, it gets down to around 7 times normalized earnings.

What would 7 times normalized earnings mean for the S&P 500? Normalized earnings in the next year for the S&P 500 will be around $67 a share. 7 times that gives you a value of $469 for the S&P 500, roughly 52% below today’s closing price of around $970 on the S&P 500. That would correlate to a Dow Jones Industrial Average of $4,500.

I’m not saying we’ll get that low. In fact, I consider that quite unlikely. I’m not saying I want to see it go that low–I’d feel terrible if it did. But, I am saying be prepared for it to go that low just in case it does.

Benjamin Graham, the father of value investing, once said you shouldn’t invest in the stock market unless you’re ready to see your investment cut in half and double in value. I agree with that sentiment. Be prepared for the worst, hope for the best.

On a brighter note, the stock market usually trades at an average of 15 times normalized earnings. That would mean an S&P 500 of around $1,000 and a Dow of $9,600. In other words, the market is already below fair value.

The problem is the stock market almost always goes below fair value after boom times. It already has, but could go lower still. Be prepared for how low it can go and don’t sell at the bottom.

Like I said above, I’m finding the best values I’ve found in years. Great companies are selling at prices that are likely to generate very high returns over the long run. Even if things go significantly lower, this is an absolutely great time to invest!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Advertisements

Credit markets still crashing

Although I’d love to see the US economy recovering, I believe that the credit meltdown is still on-going.

After listening to several conference calls, including American Express, Target, CarMax and Lab Corp, it sounds like the US consumer is still struggling in a major way.

Another sign of credit market malaise can be seen in yield spreads. The spread between low and high quality credits keeps getting wider, and this is a sign of continued credit market weakness.

How big of an impact do credit markets have on the US economy and US businesses? Very big.

It’s easy to see why businesses must borrow frequently–they must produce before they can sell, and many businesses borrow to do that. But, many don’t seem to grasp to what degree US consumers have been living beyond their means for the last decade.

US consumer debt is at record highs when compared to income and assets. Consumers are having a harder time paying their bills and their debt levels aren’t helping.

US consumers borrowed against their homes to buy stuff over the last decade.

American Express highlighted this in their recent conference call. Their customers in markets with declining housing prices are spending much less than they were a year ago–across all income levels!

Target is also experiencing difficulties with their credit racked customers. CarMax is struggling to sell cars because customers can’t get loans. Why? Because the credit markets aren’t buying car loans.

Even Lab Corp, a company that specializes in running tests for hospitals and physicians, is feeling the credit pinch. On their conference call, analysts hammered company management about their receivables and why customers weren’t paying. The answer–US consumers are strapped.

Credit markets will not recover until banks rebuild their balance sheets. Banks won’t rebuild their balance sheets until the US consumer recovers. And, the US consumer will not recover until housing bottoms.

I don’t know when that will happen, but I know it hasn’t happened, yet.

Stock markets may do well as election year uncertainty clears up this fall. But, when that is past, investors will refocus on corporate earnings, credit markets, the financial services industry, and the housing market. Until those things improve, I wouldn’t expect too much from stock markets.

(Full disclosure: I don’t own any shares of American Express, CarMax, Target or Lab Corp).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

If a shoe falls in the woods, and no one is around to hear it, does it make a sound?

In an earlier post, I brought up what could knock down credit markets. One issue was the availability of credit, which has been the subject of much pain and anguish, recently. The other two issues were interest rates and employment.

In the news today, the employment report for the month of August looked dreadful. For the first time in 4 years (when we were stumbling out of the last recession), payrolls tracked by the Labor Department shrank instead of climbing.

Could this be the result of financial service firms laying off workers in an attempt to adapt to current credit conditions? Could these laid off workers then have trouble making their home payments, thus promoting the negative spiral of home price declines, credit defaults, financial market troubles, and more layoffs?

I certainly think so. In fact, I believe this is the beginning of the other shoe dropping. I also believe the Fed will react as it always does, by lowering interest rates in an attempt to “jump-start” the economy.

This will, in time, lead to higher interest rates on longer dated bonds as foreigners demand higher rates to compensate for the dropping dollar. The dollar will drop further as more and more market participants realize the Fed will lower interest rates by printing more dollars (in other words, creating inflation).

How bad will this get? I don’t know, but lower employment and higher interest rates will make current housing problems look tame by comparison.

It’s a good time to avoid companies with lots of debt. It’s a good time to avoid investments related to the housing market or its financing (although a bit late).

More importantly, it’s a good time to be invested in securities that will benefit from this fallout. It’s a good time to have some cash that can be invested as the market goes down.

If inflation is a concern, it’s a good time to consider investing in tangible things (other than real estate) that are hedges against inflation. It’s not a bad time to consider foreign investments that may be hedges against inflation, too.

It’s also a great time to consider those companies that will fair best as we emerge from our credit market problems and into another growth up cycle.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday’s articles

I read several enjoyable articles today that put the market’s current situation in context.

The first is by John Hussman of Hussman funds. In it, he takes the Fed Model to task. The Fed Model says that the stock market’s earning yield can be compared to the yield on 10 year US Treasury bonds. As he clearly shows, this model looks great from 1980 to 1998, but would have given terrible investing advice from 1948 to 1980 and from 1998 until now. Does that sound like a good guide to investing–a method that worked during only 30.5% of post WWII stock market history?

He also takes to task the current practice of saying the stock market is reasonably priced by looking at forward price to earnings ratios and comparing that to historical trailing price to earnings ratios. Not only is this comparing apples and oranges by comparing projections and history, but it also ignores that profit margins are at all time highs and will almost certainly come down over time. As usual, his analysis brings a broader historical context to the situation.

The second is by Edward Chancellor (author of Devil Take the Hindmost: A History of Financial Speculation) and appeared in the Washington Post. His title is, “Look out. This crunch is serious.” In it, he argues that comparing current market problems to the short term problems of 1987 and 1998 may not be valid. His warning is that credit splurges have turned into major market problems in the past, and this one may look more like 1929 when everything is said and done.

The third article, in the Financial Times, is by Gillian Tett. In it, Tett argues that bond insurers, like MBIA and Ambac, may be in for serious trouble because they’ve insured so many structured financial products that contained bad credits. As he suggests, it’s very hard to know what these bond insurers have backed, so holding on to them as investments may prove foolhardy if it turns out they must actually support the insurance they’ve underwritten.

The last is by Bill Gross, of PIMCO, and appeared in Fortune. Gross compares current market turmoil to playing Where’s Waldo. Everyone seems to know a lot of bad credits are “out there,” but no one seems sure who is exposed to such fallout and by how much. Problems keep turning up in unexpected places, like German and French bank’s books. These problems were created by financial wizards on Wall Street who believed they could turn lead into gold, and, unbelievably, some people actually believed them!

In my opinion, it will take a long time to fully understand the severity of the current situation. This may turn out to look like 1987 or 1998, but it could also be much worse. For those who believe that credit excess always ends badly, it’s a great time to play defense and bet on those who can benefit from debt implosions.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.