Take this week’s equity drop seriously.

Longs are playing with fire here. This market is at least as dangerous as 2007 or 2000. What happens when this multi-decadal asset mania fizzles out, like they all do? The last 12 months show that it won’t give up the ghost without a fight, but it is very long in the tooth, as is this huge rally. Also, the short-term action of smooth rallies followed by sudden drops is uncannily similar to 2007.

Stocks left the atmosphere in 1995, but since 2000 gravity has been re-asserting itself. After extreme overvaluation comes extreme undervaluation. On today’s earnings and dividends, even average or “fair” multiples would put the Dow near 4000, right back to 1995.


Charts from Stockcharts.com

A note on gold and the dollar:

I suspected a few weeks ago that gold had a rally coming, and now that we’ve seen it I’d be careful to use stops and not get too confident.

I still like gold for preservation of purchasing power through this secular bear market in real estate and stocks, but when financial markets turn down again in earnest it won’t be spared. Remember, it kept going to new highs in late 2007 and early 2008 after stocks had peaked, but then tanked with everything else when panic hit. Cash is still king, especially in US dollars and Treasury bonds. We may have only seen the start of this deflation.

Analysts and institutions: stocks “extremely cheap” despite 1.7% yields after 80% rally. Hussman & Prechter: another crash likely.

Bloomberg today gives a tour of the bull camp, which believes in a V-shaped recovery and soon-to-be record S&P earnings:

Even after the biggest rally since the 1930s, U.S. stocks remain the cheapest in two decades as the economy improves…

…Income is beating analysts’ estimates by 22 percent in the first quarter, making investors even more bullish that the rally will continue after the index climbed 80 percent since March 2009. While bears say the economy’s recovery is too weak for earnings to keep up the momentum, Fisher Investments and BlackRock Inc. are snapping up companies whose results are most tied to economic expansion.

“The stock market is incredibly inexpensive,” said Kevin Rendino, who manages $11 billion in Plainsboro, New Jersey, for BlackRock, the world’s largest asset manager. “I don’t know how the bears can argue against how well corporations are doing.”

S&P 500 companies may earn $85.96 a share in the next year, according to data from equity analysts compiled by Bloomberg. That compares with the index’s record combined profits of $89.93 a share from the prior 12 months in September 2007, when the S&P 500 was 19 percent higher than today.

Those figures would be for operating earnings, not the bottom line. In recent years it has been increasingly common to simply call operating earnings “earnings” and to imply that multiples on this figure should be compared to historic multiples on the bottom line. Ken Fisher, readers may recall, was running obnoxious video web ads through 2007-2008 touting a continued rally just before stocks fell off a cliff. His equity management firm makes the most money if people are all-in, all the time, as it collects fees as a percent of assets.

Record Pace

The earnings upgrades come as income beats Wall Street estimates at the fastest rate ever for the third time in four quarters. More than 80 percent of the 173 companies in the S&P 500 that reported results have topped estimates, compared with 79.5 percent in the third quarter and 72.3 percent in the three- month period before that, Bloomberg data show.

It is impressive how companies have protected themselves since the downturn began, but the way they have done this is by simply cutting costs, hence the stubborn 9.5% (headline U-3) or 17% (U-6) unemployment rate.

David Rosenberg, as usual, is the cooler head in the room:

Alternate Valuation

David Rosenberg, chief economist of Gluskin Sheff & Associates Inc., says U.S. stocks are poised for losses because they’ve become too expensive. The S&P 500 is valued at 22.1 times annual earnings from the past 10 years, according to inflation-adjusted data since 1871 tracked by Yale University Professor Robert Shiller.

Economic growth will slow and stocks retreat as governments around the world reduce spending after supporting their economies through the worst recession since the 1930s, said Komal Sri-Kumar, who helps manage more than $100 billion as chief global strategist at TCW Group Inc. The U.S. budget shortfall may reach $1.6 trillion in the fiscal year ending Sept. 30, according to figures from the Washington-based Treasury Department.

“The correction is going to come,” Sri-Kumar said in an interview with Bloomberg Television in New York on April 21. “You now have a debt bubble growing in the sovereign side, and we’re slow to recognize how negative that could be.”

We are still in the thick of the largest credit bubble in history. Consumer and real estate debt has yet to be fully liquidated (and hasn’t even started in China), corporate indebtedness is the highest ever, and now government debt has reached the point of no return where default is inevitable.

Equity is the slice of the pie left over after all debts are serviced, so to say that it is cheap when it only yields 1.7% (in the case of S&P dividends) is insane. It is much safer to be a creditor of a business than an owner, so debt yields should be lower than equity yields. In today’s perverse investment climate, even 10-year treasuries of the US and Germany yield more than twice equities.

This extreme confidence in stocks and dismissal of risk considerations further indicates that this is a toppy environment, highly reminiscent of 2007.

John Hussman explores this theme a bit further in his latest market comment:

As of last week, our most comprehensive measure of market valuation reached a price-to-normalized earnings multiple of 19.1, exceeding the peaks of August 1987 (18.6) and December 1973 (18.3). Outside of the valuations achieved during the late 1990′s bubble and the approach to the 2007 market peak, the only other historical observation exceeding the current level of valuation was the extreme of 20.1 reached just prior to the 1929 crash. The corollary to this level of rich valuation is that our projection for 10-year total returns for the S&P 500 is now just 5.3% annually.

While a number of simple measures of valuation have also been useful over the years, even metrics such as price-to-peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were about 50% above the historical norm – reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity-oriented industries. Accordingly, using price-to-peak requires the additional assumption that the profit margins observed in 2007 will be sustained indefinitely. Our more comprehensive measures do not require such assumptions, and reflect both direct estimates of normalized earnings, and compound estimates derived from revenues, profit margins, book values, and return-on-equity.

That said, valuations have never been useful as an indicator of near-term market fluctuations – a shortcoming that has been amplified since the late 1990′s. The lesson that valuations are important to long-term investment outcomes is underscored by the fact that the S&P 500 has lagged Treasury bills over the past 13 years, including dividends. Yet the fact that these 13 years have included three successive approaches (2000, 2007, and today) to valuation peaks – at the very extremes of historical experience – is evidence that investors don’t appreciate the link between valuation and subsequent returns. So they will predictably experience steep losses and mediocre returns yet again. Ironically, before they do, it also means that investors who take valuations seriously (including us) can expect temporary periods of frustration.

I’ve long noted that the analysis of market action can help to overcome some of this frustration, as stocks have often provided good returns despite rich valuations so long as market internals were strong, and the environment was not yet characterized by a syndrome of overvalued, overbought, overbullish, and rising yield conditions. In hindsight, the stock market has followed this typical post-war pattern, and we clearly could have captured some portion of the market’s gains over the past year had I ignored the risk of a second wave of credit strains (which I remain concerned about, primarily over the coming months).

It is important to recognize, however, that even if we had approached the recent economic environment as a typical, run-of-the-mill postwar downturn, we would now be defensive again, as a result of the current overvalued, overbought, overbullish, rising yields syndrome. I do recognize that my credibility in sounding a cautious note would presently be stronger if I had ignored further credit risks and captured some of the past year’s gains. But the awful outcome of this same set of conditions, which we also observed in 2007, should provide enough credibility.

Hussman proceeds to offer a detailed statistical analysis of how valuation and market action impact risks and returns. Curious parties are encouraged to read his essay in its entirety.

Here is how he rather bluntly sums up the current environment:

As of last week, the Market Climate in stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically produced periods of marginal new highs, slight declines, and yet further marginal highs, followed somewhat unpredictably by nearly vertical drops. I’ve often accompanied the description of this syndrome with the word “excruciating,” because the apparent resiliency of the market and the celebration of each fresh high, can make it difficult to maintain a defensive stance. Interestingly, the analysts at Nautilus Capital recently noted that the most closely correlated periods in market history to this one were the advances of 1929 and 2007. While exact replication of those advances would allow for a couple more weeks of further strength, we’ve generally found it dangerous to expect history to do more than rhyme. These hostile syndromes have a tendency to erase weeks of upside progress in a few days.

I have to agree with this assessment as well as that of Robert Prechter that this spring offers perhaps the greatest short-selling opportunity in history.

Valuation still matters

Many great traders could care less, but investors need value, and there has been none in the US stock market as a whole since about the early 1990s, and no great value since about 1984. Value means getting a lot for your money, and in stocks that means of course earnings, dividends and (honestly priced) assets.

David Rosenberg is about the only bearish mainstream economist left, all the others having drunk too much Keynesian cool-aid and succumbed to the fallacy that Fed printing and government spending is stimulative (is is the opposite). In this morning’s Breakfast with Dave he warns again that fundamental or long-term investors have business touching the stock market at these prices:


Never before has the S&P 500 rallied 60% from a low in such a short time frame as six months. And never before have we seen the S&P 500 rally 60% over an interval in which there were 2.5 million job losses. What is normal is that we see more than two million jobs being created during a rally as large as this.

In fact, what is normal is for the market to rally 20% from the trough to the time the recession ends. By the time we are up 60%, the economy is typically well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended. In other words, we are witnessing a market event that is outside the distribution curve.

While some pundits will boil it down to abundant liquidity, a term they can seldom adequately defined. If it’s a case of an endless stream of cheap money, we are reminded of Japan where rates were microscopic for years and the Nikkei certainly did enjoy no fewer than four 50% rallies and over 420,000 rally points in a market that is still more than 70% lower today than it was two decades ago. Liquidity and technicals can certainly touch off whippy tradable rallies, but they don’t take you all the way to a sustainable bull market. Only positive economic and balance sheet fundamentals can do that.

Another way to look at the situation is that when you hear and read about “liquidity” driving the market, it is usually a catch-all phrase for “we have no clue” but it sounds good. When we don’t have a reasonable explanation for what is driving prices our strategy is to watch from the sidelines and express whatever positive views we have in the credit market and our other income and hedge fund strategies.

I wholeheartedly agree with his take on the word liquidity as it is thrown about these days. All it really seems to mean is that people are bullish and in the mood to take on risk — most assets were perfectly liquid throughout the crash (that is, there were plenty of buyers), packaged mortgage debt included. The banks only pretended their assets were unsaleable because they didn’t like the bids, which, as it turns out, were perfectly reasonable given the reality of default rates and shrinking collateral values.

Rosenberg goes on to discuss exactly how ridiculous the valuations are, even given the extremely rosy earnings forecasts, which seem to imply that Goldilocks was only taking a little nap and that it is not true that she was torn to shreds by the bears:

As for valuation, well let’s consider that from our lens, the S&P 500 is now priced for $83 in operating EPS (we come to that conclusion by backing out the earnings yield that would match the current inflation-adjusted Baa corporate bond yield). That would be nearly double from the most recent four-quarter trend. Not only that, but the top-down estimates on operating EPS, for 2009 are $48.00 for 2009; $52.60 for 2010; $62.50 for 2011; and $81.00 for 2012. The bottom-up consensus forecasts only go to 2010 and even for this usually bullish bunch, operating EPS is seen at $73.00 for 2010, which means that $83.00 is likely a 2011 story. Either way, the market is basically discounting an earnings stream that even the consensus does not see for another two to three years. In other words, this is more than just a fully priced market at this point.

It is, in fact, deeply overvalued at this juncture. Imagine that six months after the depressed lows we have a situation where:

The trailing price-earnings ratio on operating EPS is 26.5x. At the October 2007 highs, it was 18.8x. In addition, when the S&P 500 is trading north of a 26x P/E multiple on trailing operating earnings, history shows that at these high valuation levels, the market declines in the coming year 60% of the time.

The trailing price-earnings ratio on reported EPS is 184.2x. At the October 2007 highs, it was 23.4x. In fact, just prior to the October 1987 crash, the P/E ratio was 20.3x (not intended to scare anyone).

The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the market is trading as it if were at a peak for the cycle, not any longer near a trough. Once again, and we don’t intend to sound alarmist, the price-to-dividend ratio just prior to the 1987 crash was 12x, and at the time, the S&P 500 was viewed in many circles to be at an extended extreme.
Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which of course will never occur again. Fine, on one-year forward (operating) earning estimates, the P/E ratio is now 15.7x, the highest it has been in nearly five years. At the peak of the S&P 500 in the last cycle — October 2007 — the forward P/E was 14.3x, and the highest it ever got in the last cycle was 15.4x. So hello? In just six short months, we have managed to take the multiple above the peak of the last cycle when the economic expansion was five years old, not five weeks old (and we may be a tad charitable on that assessment). As an aside, the forward multiple on the eve of the 1987 stock market collapse was 14x and one of the explanations for the steep correction was that equities were so overvalued and overbought that it was vulnerable to any shock (in that case, it came out of the U.S. dollar market). It certainly was not the economy because that sharp 30% slide took place even with an economy that was humming along at a 4.5% clip.

The entire article (sign up for emails) is worth a read. There is much more good stuff in there on housing, manufacturing, commodities and household net worth. Savvy contrarian that he is, he also had these kind words to say about the US dollar:

We do not like the U.S. dollar at all, but at the same time, from a purely tactical standpoint, we have to recognize that there are no U.S. dollar bulls out there right now, the bearish dollar trade is the crowded consensus trade, and that the greenback is massively oversold. It could snap back near-term — be aware of that, please.

Do P/E’s matter?

Source: Irrational Exuberance, Robert Shiller, 2000

The average 12 month earnings for the S&P 500 from June 2000 to June 2009 (10 years) is $49.84.  The index earned $14.88 in 2008 and $7.62 in the 12 months through June 30, 2009. The respective PE’s at a value of 1000 are roughly 20, 65 and 130.

Assuming earnings soon rise to $50 and are sustained, a tall order in my opinion, the expected 20-year annualized return on the S&P would still only be about 1%. Is that enough to justify the risk that earnings do not recover? Shiller’s method of smoothing earnings over 10 years makes good sense, but what if that 10 years encompassed the greatest credit bubble in history, and it has now been popped? What is the expected return then? To look at it another way, I would say that your expected return on T-bills is very, very high in terms of stock.

The Global Dow needs to crash some more.

Last fall, Dow Jones launched the Global Dow index, composed of 150 stocks from around the world. A quick glance at its 10-year chart shows that stock prices have only so far blown off the froth from 2006 and 2007:

Source: wsj.com

Stocks are driven by mood, and mood today seems to be highly coordinated around the globe, so rather than scrutinize the twists and turns in the Dow, DAX or Nikkei, perhaps this new index is the best reference.

What is most striking about this picture, as opposed to that of the S&P500, Eurostoxx 50, or Nikkei, is that stock prices are only 2/3 of the way back to the 2002 lows, as opposed to right upon them.

This says to me that even this first stage of the crash has further to run. Fundamentals are deteriorating with blazing speed, but market participants remain in secular bull market mode. Too many are still buying the dips, or at least ignoring their losses and hoping for a rebound. The stock market is still viewed by most Americans as the best way to save for retirement, and the myth persists that if only your time horizon is longer than a decade or so, stocks will always beat cash.

This wave off of the November lows is looking weaker and weaker. We had our chance for a strong bounce like the one after the crash of ’29 (the Dow was up about 45% from November ’29 to April ’30), and all we could muster was about 20%.

Today’s action is a pretty strong indication that panic has been lurking just below the surface. With the sell-off in bonds possibly having run its course, precious metals stalling out at resistance, and a very low put/call ratio indicating extreme trader optimism, the news of the Great Pork Package and latest bankers’ bailout may be just the catalyst we need for a sell-off. Hope is fading fast.

Oh, and it is worth mentioning that John Mauldin reports that a contact at S&P told him that the latest quarter’s earnings are apparently coming in at a NEGATIVE $7 for the index. I have been saying all along, that if this is a depression (it is), PE’s should bottom out at well under 10 and even dividend yields should be in the double digits. Whatever figure you come up with as a final bottom target for the S&P, it should be a very low multiple of very low earnings.

My screen is still cluttered with overpriced stocks.

This bubble was so extreme by any standard but Tulip Mania, that even after a 40% fall, the exchanges are full of junk stocks priced to go down another 40-100%. Where are the earnings? Where are the dividends?

Here are some prime examples:

  • Home Depot. How on earth is this company supposed to make money in the future? It is still priced at 10X last year’s earnings, and we were just entering a recession then. What will they do in the depression?
  • Blue Nile. It’s a great business concept, but how many diamonds are going to sell at retail next year, and the year after that, and after that? How do you put a 38-handle on last year’s earnings when the business is toast and they don’t even pay a dividend? Also take a look at Zales and Tiffany while you’re at it.
  • REITs, poor REITs. Kind of hurts to have to service all that debt with tenants dropping like flies. Expect zero equity to bring zero bids on a few of these before 2009 is out. Many are still down less than 50% from the crazy prices of 2006.
  • FedEx. Still a trailing PE of 20 and dividend yield at 0.6%! That’s a long ways from value. The stock ought to be priced at 5X last year’s earnings, because they will be lucky to see any next year.

I could go on and on. Stocks are still ridiculously overpriced. If you have Buffett-esque skills, you might be able to find the needle in the haystack that will hold up from here, but why swim against the tide? Your cash goes up in value every day.

Brave New World

The world from 2008 forward will be completely different than the last 60 years. Enormous shifts are taking place that will disrupt every business model and interrupt earnings in a major way. That has only begun to be discounted. This is not 1929, which was just a setback in the growth of western civilization. The utter economic cluelessness of the elite and middle class alike is paving our road to serfdom. My advice to anyone who doesn’t want to live in a Huxley or Orwell novel is to make like Jim Rogers and head east.