In my opinion, and as I have made the case for several years, this market is too high compared to historical trends of value. In my opinion, it has much further to go on the downside. But secular bear markets do not go straight down to "fair value." It takes years of going down, with large rallies back up and then more down before the bottom is finally reached. At every step, there are advisors and investors who decide that "now" is a good time to invest. There is no mass consensus.
Remember, over half the years within a secular bear market cycle are up years, and most of those are up by 20% or more. As the fairly bearish Dan Denning wrote in Strategic Investment today: "...confidence can be a heady thing. If Hussein ends up dead and Osama bin Laden is captured, look for 10,000 on the Dow in short order. Euphoria is a powerful emotion."
Those who feel the market is over-valued have ample justifications. You can go to Standard and Poor's website and look at their valuations. If you take pro forma earnings (that is Earnings Before Interest and Hype) the current P/E ratio is 18, which is high, but certainly within historical norms. But if you look at actual "as reported" earnings, the P/E ratio jumps to 30.29. That is in nose-bleed territory to the historical average of 15.
If you look at core earnings, the number is over 35. Core earnings subtract options expense and pension fund overstatements. The new accounting standards will probably mandate firms to start subtracting these items, so the core earnings P/E ratio is a number that is increasingly going to be seen by the investor.
Not fair, say the bulls. To get true historical comparisons, you have to compare apples to apples. The new standards distort the actual profitability of a company, and give us no fair historical comparison.
To that, I politely say bunk. Pre-1990, pension benefits did not have nearly the impact that it does today, as there was not that much over- funding and estimates of future earnings were far more conservative. It is only in the decade of financial engineering, where a CEO could create a 10% rise in his company earnings just by changing the assumptions of his company pension fund that these elusive pension fund earnings started to show up in the books in a significant way.
Of course, that helped the CEO's personal options, which again the company did not have to expense. Options were not a big deal prior to 1980 and not all that significant even until 1990.
Accounting standards always tighten up in bear markets. Investors become more conservative. They are not willing to project earnings growth far into the future. That is why the market drops.
If you go to Decisionpoint.com, you can see in one of the many hundreds of charts available that if the P/E ratio for the S&P 500 were 15, about average for the last century, the market would be at 420 today. As markets have always over-corrected, generally to below single digit P/E ratios, if it went to 10, the S&P 500 would be at 280, down 68% from here. That is pretty ugly.
I believe we are going to single digit ratios. I also believe it will take a decade or more. In that time, earnings will grow, and probably double or more without having to be too optimistic. What happens in secular bears is that earnings grow and P/E ratios drop. But it does not happen all at once. It takes time.
We can be thankful for that, because if the markets were to drop 68% today, we would be facing a depression as severe as our grandparents faced. It would be ugly, ugly, ugly. Thus, in a kind of perverted logic, we should be grateful for market cheerleaders, as they prop up the economy and stave off a disaster scenario. But as individuals, we don't have to listen to them.
The point is that there are those who see the market as under-valued. When it does not go up they blame hedge funds, short sellers and wicked analysts for their losses. There are those who see the market as over-priced and want the market to conform to their worldview, and they see rallies as evidence of the Plunge Protection Team. The world is not as it should be, and there must be some secret reason. That is especially true if they are short and the market goes up.
The real reason is what Richard Russell says over and over, "The market is the market. It just is." In a real sense, this is more scary than the possible existence of a plunge protection team. It means we are subject to the vagaries of a market which is out of anyone's ability to control. I bet there have been a few times you wish someone could have made the market go back up. In a world where anything can happen, risk control is everything. It would be nice to know that I could count on some secret group to protect my funds, but it doesn't exist. I am responsible for my own risk protection and personal portfolio.
Randomness and Responsibility
Thus, we return to Art Cashin's final bit of wisdom: "People can't stand two things - randomness and responsibility. On the first point we again cite Voltaire: "If God did not exist, it would be necessary to invent him." The premise is obvious and a truism - life must have order. The class needs rules and a teacher. An occasional accident is acceptable, though maybe not understandable. The logical (for many of us) existence of a deity transmutes in the secular world into - someone is in charge. (The government, the moneyed interests, some religious or ethnic group, etc.)
"Now factor in the inability to accept responsibility.
"If my horse doesn't win - the race was fixed - the horse was doped. The variations are myriad. It can never be my fault or my miscalculation. That could mean I was careless, or confused or hasty or maybe even wrong. The latter is unacceptable so it must be someone else.
"Thus conspiracy theorists and the plunge protection theme. In four decades, I've heard hundreds of theories. The collapse of the Hunt Brothers' silver bubble was roundly blamed on a government conspiracy. As time went on it was obvious there was no conspiracy - not there or in hundreds of other cases. But....when your perfect game is ruined in the final frame (bowling) or the final inning (baseball) - dashed hopes demand a villain - an evil deus ex machina. They stole it from me, I tell ya!!"
Time Out
It is late on a Friday evening. I have had more distractions on my Friday e-letter writing afternoon than any time in recent memory. There are a dozen other topics that deserve mentioning. Steve Roach of Morgan Stanley now predicts the world will slide into a double dip recession as the SARs virus hits the world economy. Housing remains strong, yet the IMF warns of a bubble in housing. Dennis Gartman reports shipping rates and shipping is up, which means world trade may be improving. Unemployment is up, manufacturing is down, and the service industry is in contraction mode.
In short, it does not look good for my Muddle Through scenario. While I clearly think we will have another recession, at the beginning of the year, I thought we could avoid it for 2003. Now, I seriously have questions about that prediction. And yet, the economy will probably have grown a little more than 1% in this last quarter, and it looks to do so in the second quarter. Could an end to the war create that euphoria Denning mentioned. Stay tuned, as I will just have to address this next week.
Speaking of conspiracies, my Dallas Mavericks lost to the Lakers last night. I was right down front, and I can tell you that there was clearly a conspiracy among the referees to allow Shaq to get away with anything. You could see them looking at each other. I saw all sorts of winks and hand signals. We were robbed.
