Where are we in the secular (post-2000) bear?

Mish Shedlock’s investment management company, Sitka Pacific, provided this chart in their September letter (as a non-client, I only get delayed copies):

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One lesson to be learned here, which they get into in the letter, is that prices bottom before valuation multiples. In the bears of the 1910s, ’29-early 40s and ’66-82, inflation appeared late in the game. BTW, this meshes with Kondratieff theory, where inflation leads to disinflation to deflation then inflation again, with asset values moving in tandem.

So, be prepared to buy in this coming wave down, if we get a nice drop over the next year or so, because select equities could be a nice hard asset to own through the turmoil in the currency and sovereign debt markets, which is likely to spread to the US, UK, Germany and Japan by later this decade.

Long term Russell and Nasdaq charts

These two have the furthest to fall, and are really still in the process of making an historic secular bull market top.

The Russell looks like it’s forming a giant head and shoulders:

Prophet.net

See those RSI trends on the bottom? This is a market that’s running out of steam. We know from mutual fund reports that managers are already “all in” again as of January, and as Richard Russell says, it takes buying to put stocks up, but they can fall under their own weight.

And the NASDAQ 100 is back at 1999 or 2007 levels! These indexes, like Chinese and Indian stocks, show that the world still has an astounding appetite for risk in the face of depressionary business conditions. It was one thing to pay 100 times earnings when the credit expansion was still going and almost nobody knew how the story ended, but now that it is plainly over, what are people thinking?

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Russell 2000 yield: 1.2%

Nasdaq 100 yield: 0.49%

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Stocks in the Nasdaq 100 with zero dividends:
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Adobe Systems
Amazon
Amgen
Apollo Group
Apple
Autodesk
Baidu
Bed Bath & Beyond
Biogen Idec
BMC Software
Celgene
Cephalon
Cerner
Check Point Software
Cisco Systems
Citrix Systems
Cognizant Technology
Dell
DirecTV Group
Dish Network
eBay
Electronic Arts
Express Scripts
First Solar
Fiserv
Flextronics International
FLIR Systems
Foster Wheeler
Genzyme
Gilead Sciences
Google
Henry Schein
Hologic
Illumina
Intuit
Intuitive Surgical
Lam Research
Liberty Interactive Series A
Life Technologies
Logitech International
Marvell Technology
Mylan
NetApp
NII Holdings
NVIDIA
O’Reilly Automotive
Patterson Companies
Priceline
Qiagen
Research In Motion
SanDisk
Seagate Technology
Sears Holdings
Starbucks
Stericycle
Symantec
Urban Outfitters
Verisign
Vertex Pharmaceuticals
Warner Chilcott
Yahoo
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After the last year’s action, it should be abundantly clear that fundamentals do not drive stocks, and they only offer resistance and support at the most extreme heights and bottoms. Herding behavior, animal spirits, fear and greed are what make the tickers tick.
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That said, we are now entering a long phase of value restoration. By the end, people will talk about steady cash flow and yield again, as they did in 1982 and 1942. It will take a lot more than the above to lure them in, and since there are no more miracle cures for the numerator in the yield equation, the denominator will have to come down to earth.

Earnings check: quietly revising down

Here’s a snapshot from the latest S&P 500 earnings file (paste the following link into your browser or google “S&P 500 earnings” for the whole Excel file: www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS):

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The average estimate for 2009 earnings is now under $40 (for a PE of 27 using today’s price), since Q3 and Q4 have been revised way down from earlier this year. Now analysts think Q4 could only come in $1 better than Q1, which was horrible.

These numbers make you wonder if accountants used up all of their tricks to boost the bottom line in Q2. The reality of shrinking sales and margins can’t be hidden forever.

The estimates for 2010 and 2011 earnings are now $45 and $61, respectively, and 2009 dividends are projected at $22 (back to 2005 levels from $28 in 2008, for a piddling 2% yield). Even if profits recover as projected, the market will have to maintain the current extreme multiple in order to deliver gains over the next two years. We are already trading at 18X 2011 earnings! The PE at the peak in 2007 was 19, and look at where that got us.

My own take on earnings is that we will be lucky to see $30 in 2010 or 2011 for that matter. The debt overhang remains, and underlying asset values are so much lower than they were 12 months ago that another huge round of write-offs is needed, which will directly hit the bottom line. Households are digging in, and banks are still pulling in credit. The consumer economy is not coming back, and corporate America will take years to adjust.

Stock prices are so far from fundamental support of any kind that this market has to be counted among the greatest bubbles of all time. Many observers understand that this is a bubble, and are wondering what it will take to bring prices back in touch with reality. My answer is nothing — the market will simply turn with social mood, which has no master but god. The facts are always there, but traders aren’t always in the mood to check.

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How low can stocks go? The polite version.

News flash: Stocks can go down.

Funny how people forget these things. It just goes to show how market prices are at least as much about psychology as fundamentals.

At their core, stocks represent two things: a claim on any future earnings that might be generated, and a company’s net assets. These values are both dependent on people’s sentiments about the future, which swing from optimism to pessimism over time scales as small as an hour or as long as several decades.

Earnings and asset prices are highly variable, especially when debt is employed as liberally as it has been lately. Debt overload destroys economies, because it creates massive distortions in asset prices and risk perception. The boom phase is the destructive phase, because those distortions result in waste. The bust is simply taking an honest accounting of that waste, and it cannot be stopped, and should not be fought, because it restores sanity in the form of market-clearing prices.

Leverage works both ways.

Busts destroy both earnings and net asset values. As asset values drop, leverage increases the destruction of equity.  Lehman, Bear Stearns and others were levered 30:1, so their equity went POOF with just a 3% decrease in asset prices. A retail margin stock account can be levered 3:1, so if somebody put it all into Apple at 180 in August, they would have been wiped out by last week.

Recently, even big industrial firms have levered up so that they could grow-grow-grow and vest those stock options. In the bust, their earnings and asset values (real estate, equipment, subsidiaries) drop, but the debt doesn’t go away. It should therefore come as no surprise that equity values routinely drop by 75% or more in bear markets, but it always does, because each generation has to make its own mistakes.

By the numbers.

Here’s a little back of the envelope calculation I use to sober up the buy-and-holders:

Everyone knows about PEs. For the market as a whole, 10 is pretty cheap, and 20 is pretty expensive. Now, PEs are not everything, since you have to look at the earnings cycle, too. A lot of big gold miners had very high or infinite PEs when the metal was under $300, but they were still a great buy. Lehman and Bear Stearns had PEs last year of about 10.

Earnings for the market as a whole are very volatile. (S&P publishes historical data here — big Excel file available.) Forget about “operating earnings.” I believe it was Charlie Munger, the Berkshire partner who has not turned communist in his old age, who said that every time you hear operating earnings, you should substitute the phrase “bullshit earnings.” What you want are real, reported earnings. PEs should be based on the last year’s bottom line, not what a bunch of ass-kissing analysts are told to tell you they think this year’s or next year’s earnings will be.

So, if we are in a real recession and a real bear market (by the way, real bear markets last at least three years), what does that mean for earnings and PEs?

For this discussion I prefer to use the S&P 500, since it is a broad index with copious data available:

S&P 500 earnings peaked about about $80 for the index in 2006, up from a little trough of $44 in 2001. The index peaked last year a bit north of 1550, for a PE on peak (real trailing) earnings of just under 20. Pretty darned rich when you consider that earnings were about to fall off a cliff, though the aforementioned cheerleaders kept telling us how cheap stocks were at the time.

According to S&P, the first two quarters of 2008 have come in with earnings of about $15.50 and $13.20, respectively, for an annualized rate of something like $57. Apply today’s S&P 500 closing price of 1106 and you see that we are on track for a PE of 19.4 if earnings stay steady from here.

But real bear markets end with PEs under 10. In bear markets, social mood becomes more pessimistic and people have less faith in future earnings. The multiple hovered around 8 in the doldrums of the late 1970s and early 1980s, and bottomed at about 7 in 1932. Let’s be nice and apply a PE of 10 to today’s $57 in somewhat bullshit forward earnings: that of course would give us 570 on the S&P, a drop of over 60% from last October (this would correspond to about 5000 on the Dow).

Think earnings will be even worse next year than in the little 2001-2002 recession? Well, better revise those figures accordingly. I personally assume at least a 50% drop in earnings from 2006 and a PE under 10, for a Dow somewhere under 3500. That is, if all goes well.

Bear markets happen. It’s the stock market, people.

You see, it’s no big deal for stock markets to fall by well over 50%, if not 90%. It’s just big deal for Americans, because they have been lulled into complacency by a 26-year bull market. They should have been saving more all these years, and in a more reliable form than the stock market. Too bad their great-grandparents weren’t around to warn them.