Market Action, March 2 2009 - The Market is Going to Zero (and All That)

Some random thoughts.

Today, the S&P 500 was down 4.6%.  Since the peak on October 11, 2007, the S&P 500 is down 56%.  It is also down

• 26% since the high on January 5 (39 trading days ago)
• 20% since the high on February 9 (15 trading days ago)
  
• 10% since the high on February 26 (3 trading days ago)

We are deeply oversold.

But who cares?  The market can do nothing but go down.

Why?  From the rumor department

I think at 6500 the market properly prices in the fundamentals of the economy but my friends at a few fund of funds are telling me that forced selling by hedge funds is driving the market. Investors just want their money back and heavy redemptions will likely begin again next month. So there is a good chance the market goes much lower and there is nothing one can do even though stocks are screaming cheap - that is because the arbs that would take advantage of the mispricing are the very same ones being forced to sell. Hence, there is no buying support. That's why I say this is the stock market equivalent of a bank run - technical phenomena.

Markets can and will do anything.  They can and will go further than you or I could ever imagine. 

Of course, at extremes, the predictions get more and more wild.

I remember being in a meeting in March of 2000 when a well-known money manager said to me that technology was going to get to 67% of the S&P 500 within the next few years.  Tech was 35% at the time.  I just shook my head.

Likewise, we are getting more and more extreme as the market goes lower.  Today, one bulge-bracket (are there any left? - ed.) technician speculated the S&P 500 could get to 280, which would retrace the 1929-1932 decline.  (More on that in a minute)

Remember, the uber-bears will overplay their hand!

Rare was the uber-bull during the tech boom who got you out at the top.  I imagine (most of) the uber-bears will fail to get you in, or cover your shorts, at the bottom. 

Now, could the market fall 87%?  Of course it could!  Markets can and will do anything. 

Is it likely?

No.  Not impossible, but unlikely.

I do not invest nor trade based on extreme events.  I believe that it is prudent to scale into and out of positions as the market approaches extremes on both the upside and the downside.  Thus, I usually take a hit when I am buying and leave money on the table when I am selling.

And I certainly have been taking a hit the past few months.  I have some cash left, but not much.

I cannot help myself.  Stocks are becoming mouth-wateringly attractive!

Ignore those arguing that stocks are expensive because GAAP earnings on the S&P 500 are going to be $25 in 2008 and expected to be $32 in 2009.  That is foolish.  Roughly $30 in the decline in earnings is due to the massive write-offs in the financial sector.  To say that this is an accurate reflection of the underlying profitability of corporate America is to believe that we are going to have $1 trillion in financial asset write-offs each year for the next 10 years.  Even the uber-bears are not arguing that.

Instead, the market is trading at 10x normalized earnings.

Don't believe me?  Fine.  But get this - the median stock in the S&P 500 is trading at 9.2x 2008 earnings and 9.9x 2009 estimates.  It is even lower in the ValueLine universe.

Over a 10 year period, I cannot think of a time when investors have lost money when the median stock was valued at less than 10x earnings, even during the Depression.

Now, back to the Depression.  The technician mentioned above speculated that stocks would fall to 280 if the market fell as much as it did to the 1932 bottom.   Absolute return is the wrong metric, in my opinion.  Most likely, the bottom will be a Tobin's Q of 0.3, which marked the great bottoms of 1921, 1932, 1949 and 1982, as detailed in the excellent book, Anatomy of the Bear, which I will review in a few days.

According to Russell Napier, author of Anatomy of the Bear, a Tobin's Q of 0.3 would take us to around 400 on the S&P 500.  And what happened after the market bottomed in 1932?  Equities rose 180% in a year, and 240% within four years.  Such moves off 400 would put the S&P at 1120 and 1360 respectively.

Which is why I feel comfortable buying stocks here.  In fact, the further markets fall, the more comfortable I become.

Of course, markets may not behave the same as they did in the 1930s.  However, there is a tremendous amount of cash on the sidelines.  On Larry Kudlow this evening, Blackrock's Bob Doll stated that cash was 50% of retail investors' portfolios, an all-time high, which is consistent with what I have seen.  Thus, there is a lot of firepower on the sidelines which could probably will slingshot the market higher once it bottoms.

In fact, even though stocks fell 87% during the Great Depression, the real decline was less, somewhere around 70%.  (I do not have the inflation data in front of me at the moment, but I will hunt it down and post the inflation-adjusted returns of stocks during the Depression at another time.) 

To date, the inflation-adjusted return of the market from the peak in 2000 is 62%, almost equaling the real decline in stocks during the Great Depression!

Deflation during the Great Depression was about 20%.  (Again, I'm doing this by memory on the fly.  I will get the actual numbers later.)  During the Depression, the government did little to fight deflation, a very different response from the government today, however ham-handed they may be.  In fact, the government actively created deflation during the Depression by raising the discount rate from 1.5% to 3.5% to stem an outflow of gold in 1931.  I do not believe deflation will be anywhere near what occurred during the Depression, given the actions of the government, and that the monetary creation over the past decade primarily effected asset markets, not consumer prices.  And now, deflation is manifesting primarily in the asset markets, not in consumer prices, as one would expect.

Thus, a 70% inflation-adjusted bear market would get us to 560, another 20% decline from here.  Heck, at the current rate, we will be there by the middle of next week!

If we are going there, get it over with, I say.  The sooner the better.  Let's fall 20% tomorrow!

On a closing note, I want to give full props to one of Running of the Bulls' regular readers, Dave.  (Dave goes by the handle psychodave, but his comments are anything but psycho.)  A while back, Dave said the S&P 500 was going to 600.  Well, it has not yet gotten to 600, and it may not, but the SP traded with a 6-handle on it today, and that is close enough for me. 

Good call Dave!

Comments

[dacian]

"And now, deflation is manifesting primarily in the asset markets, not in consumer prices, as one would expect."

How's that? I thought those CPI measures are around zero?!

And about the Depression, today imbalances are higher than at that time and the bust is global. There are no driver for jobs and we have overcapacity all over; where from the next "bull market" will come? What makes you think the money on the sidelines will come in? In 2006 there were less money one the sidelines yet the stocks were going higher. Why?

It might be that this market goes back to 1990 (ie Dow at 3000) when this madness started; the market will take every penny back. Are stocks for the LT a buy here? Probably, I don't know; but I don't think a bull market is around the corner; it might be that in 5 years from now we will trade at the same levels as today on SPX.

[Toro]

Dacian

We may have some deflation, i.e. -1% or -2%. I do not think we'll have cumulative deflation of -20% or -25% as we had in the Depression. Headline inflation ran ~2% above the core rate for a few years, and I imagine that it will run ~2% below the core rate for the next few years. That will get headline inflation/deflation of 0% to -1%. That is not particularly problematic.

T.

[Fred]

S&P 500 might not bottom until it hits a P/E ratio of 5X-8X of the average of 10 years of S&P 500 earnings.

http://www.businessinsider.com/new-low-on-shiller-pe-12x-normal-trough-low-is-8x-2009-3

[psychodave]

My dysthymic anticipation was primarily due to our government's eagerness to push lotsa money into the hands of unambiguously incompetent capital allocators, rather than supporting State & Local governments and the unemployed to get through this.

Otherwise, gulp & gawrsh.

My best to Italicized Ed!

[Isam Laroui]

One of your best posts, Toro.
Good (and new to me) point about the inflation-adjusted 1929-1932 stock market decline.
As far as the hedge fund liquidation rumors, they always seem to pop up towards the end of a severe sell-off.
isam laroui

[alan smithee (nee kerry)]

The thing is, seemingly everyone has been saying that the market is headed to 600 (or 500 or whatever). I thought that was a sign to buy.

I have been waiting to buy back in. I have been asking other actuaries about ins co's, and get the impression they should be bought. stat requirements will likely be changed.

[alan smithee (nee kerry)]

oh yeah, methinks the real value is in the $1 stocks, definitely the sub$5 stocks.

[bill chan]

S&P 600 is closing in. How about DOW 4000?

http://www.marketwatch.com/video/asset/dow-could-hit-4000/1973951D-B6AB-41F1-B91D-06032C304AFB