us economy looking grim, page-4

Here is some more scary stuff from the US.

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.


Your ready for the weekend analyst,


John Mauldin
[email protected]


Copyright 2003 John Mauldin. All Rights Reserved