Saturday, October 4, 2008

Asset Class Analysis - US Equities

I, like most others, find myself paralyzed by the recent volatility in the markets. I've never experienced anything like this in my very short career. But surprisingly, that doesn't put me at any disadvantage over those who have been following markets for 30 or 40 years. They haven't experienced anything like this either. I understand that statement might raise the ire of those who have cut their teeth in this business for decades. So while I'm at it, I may as well go one step further. I suggest that economists, investment professionals and others who have been around for decades are at a massive disadvantage to others like myself, explicitly because they remember events like the S&L Crisis, 1987, LTCM, or the Asian crisis of '98. It is ingrained in their collective conscience that these crises naturally resolve themselves, and the stock market will naturally resolve upward.

For further evidence of this mindset, take a look at this excerpt from the Vancouver Province Newspaper from Tuesday, September 30,

Samir Kulkarni, 31, a personal trainer, was working on his computer on a restaurant patio. "Today would be a good day for them to hide," he said of the high-rollers. "If people are worried about their investments and their money, it's bad for me because they're going to be spending less money on things like me for example - that's disposable income. "I've seen stock-market crashes a lot of times in the past and it always goes back up," he said.

Mr. Kulkarni was obviously not around during the 1966-1982 period when stocks (adjusted for inflation) lost 50% of their value. Nor was he around during the Great Depression. His attitude is typical of Gen-Xers who think that because something hasn't happened in their lifetime, it is therefore impossible.

Luckily, the folks from which I took my early instruction on investing taught me some very valuable lessons about market psychology. For example, this Galbraith quote is one that has lingered in my mind, and has saved me quite a bit of money:

A common feature of all these earlier troubles [referring to the Panic of 1907 and the depression of '20-'21] was that having happened, they were over. The worst was reasonably recognizable as such. The singular feature of the Great Crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.

He went on...

The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market and who then bought common stocks, would see their value drop to a third or a fourth of the purchase price in the next twenty four months.

The Great Crash, 1929 by John Kenneth Galbraith
(from which this quote originates) and Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay (published in 1848) were the first two books I ever read on the topic of economics. A common theme between the topics covered in these books (Mackay's book covered the Tulip bubble in Holland, the Mississippi Scheme in France and the South Sea Bubble in England) was that the crashes were generational in nature. None of the participants in any of these examples had experienced either such prosperity nor such destitution in their lifetimes. The principle of maximum ruin was executed to perfection.

So the question confronting investors of today is: "Is this one of those generational crashes, or is it simply another crisis to be quickly resolved."

I've already made up my mind that it is one of the former for a number of reasons.

1) The natural selling pressure of Baby Boomers in preparation for their retirement.

2) The psychological reactions I am seeing. Every analyst I see on TV is looking for a bottom. Some say today is a bottom. Some say next week will be a bottom. But it is implied that because prices have been falling for so long, the bottom must be near.

3) The amount of debt and leverage in the financial system that was all created on the assumption of perpetually rising prices. Selling begets more selling. And each round of falling prices consumes even more of the pool of savings as the buyers Galbraith refers to are sucked in.

I take no pleasure in witnessing the demise of so many people's personal savings, nor am I any longer able to profit from it. Nobody gains in an environment like I describe. Everybody loses. Some more than others, however.

In addition to the typically unorthodox methods I use of generational studies and mass psychology to forecast the long-term direction of the market, I also use some other measures. I have been tracking the earnings forecasts of S&P 500 companies for a few quarters now. For the second quarter of this year, analysts surveyed by Thomson Reuters had forecasted positive earnings 4.7% higher than that of Q2 '07. Estimates fell to -2% on April 1st, and then continued to fall every week as earnings reports started being publicized. This all happened while analysts and pundits were screaming "stocks are cheap!" They were all looking at expected earnings. In November of 2007 I wrote:

Valuation methods like P/E became popular after the 2000 bubble when stocks went past all historical norms in the “new tech economy.” So now with stocks priced at an entirely reasonable average P/E of 15.5 for the S&P, analysts scream BUY! But could they be forgetting the other half of the ratio? If earnings fall, can that bring the price down without affecting the ratio? Yes, of course.

Indeed, earnings have started to fall. Q2 earnings ended up negative by over twenty percent. Q3 estimates have already fallen from modestly positive a few weeks ago to -4.8% on October 3rd. Analysts are still expecting Q4 '08 earnings for financial companies to be 200% higher than their terrible earnings of '07. They're also expecting Q2 2009 to register all-time highs in profits. This kind of optimism is already priced into the current valuations of stocks. And it is where I think things can come apart at the seams for the stock market if it doesn't transpire.

On Thursday I was talking about how last year's credit markets reflect on today's economy. And how today's credit markets will reflect on next year's economy. With the condition of our credit markets now, I cannot legitimately see how these analysts are making these predictions. It defies logic that companies will be able to post record profits only 6 months from now considering the credit markets are now closed - and for many companies they have been for a while now.

What I am trying to get across here, is that despite the pessimism in the media about the present, there is still unbridled optimism about the future. If that optimism were to change course - or worse, turn to pessimism - it's effects on the stock markets could be catastrophic.

Perhaps there is some hidden advancement that will come to light and allow these companies to put up big numbers. Perhaps the financial wizards will find some sort of way to turn water into wine. But I just don't see it. The engine for growth has been the credit markets for many decades now. And since that engine is broken, and unless another engine comes quickly to rescue us, there is only one direction for the stock market and that is down.

I say this, and at the same time I'm very tempted to buy in to mining companies like Freeport McMoran, BHP Billiton, or Gerdau. I'm tempted by shipping companies like Genco, Dryships and Diana. I'm tempted by telecomms companies like Brasil Telecom, France Telecom and Vodafone. I'm tempted by infrastructure, tobacco and utility companies. All of these are international in scope, provide juicy dividends and trade at very reasonable sub 10 P/E valuations. This is to say nothing of the junior stocks on the TSX-Venture that trade below cash value with great assets.

But I'm still waiting. These stocks are all owned by the same people that own other ones. They're owned by mutual funds and pension funds. They will be met with the same forced selling as those companies that ran themselves into the ground.

As I mentioned on Thursday. This is not about bailouts. It's not about "irrational market behaviour." And it's not about some insidious plot by 'financial terrorists' to bring about the destruction of civilization as we know it. It is about too much debt, too much leverage, and a far too optimistic vision of the future. Until those problems are realized and begin to be resolved, stocks cannot find a bottom. Debt needs to be destroyed. Overleveraged companies and individuals need to go bankrupt. And realistic expectations of global growth (or even contraction) need to be what we value earnings potential on.

The more government can stay out of this process, the faster it will come about. And the faster I can put my money to work again. Until then, I wait.

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