Watch Out For the Second Leg of the Downturn
by Thomas P. Au, CFA, Author & Market Analyst. March 18, 2009
Do you think that the crash is over, as certain former bears do? This question arises as we have breached the first downside target, of Dow 7000, based on my proprietary investment value model that was first published in thestreet.com October 24, 2007. It was less a forecast than an evaluation. The Dow has now vindicated this model by reaching “fair value,” as one would expect from a simple definition. Does that represent a base for a new bull market? Or is it just one more stop to the nether regions?
To understand my model, note that a stock can be analyzed as a combination of a bond plus a call option. My proprietary investment value metric for a stock is book value plus ten times dividends. That is a Ben Graham like construct that treats stocks almost like bonds, and gives no effect to growth over and above the pro rata return from the reinvestment of retained earnings. On the other hand, many investors prize stocks, particularly tech stocks, for their “optionality,” the hypothetical ability to generate “positive surprises” over and above what economic theory would support. At bottom, the belief in the new economy was a belief in “optionality,” that random positive events that occur from time to time, and did so with particular frequency in the 1990s, will become a recurring fixture of the economic landscape.
But such a process can also work in reverse, as it has recently. We are now experiencing what my colleague Robert Marcin calls the Great Unwind. A turbocharged economy is most likely to become “unstuck” when the conditions that initially favored it no longer exist. When this happens, an economy can grow as much below trend as it was formerly above trend, a fact that is likely to be reflected in the financial markets. History is not very encouraging on this score. In past downturns, such as those of 1932 and 1974, the Dow troughed at one half of my investment value metric, reflecting then-prevailing investor beliefs for negative optionality; that the economy will be worse than would normal economic forces would dictate. With investment value at 7000 (actually a rounded version of 6600) on the Dow, half of that would be 3300. And during the 1930s, this metric actually fell, meaning that the “ultimate” low could be half of a number lower than 6600.
So having completed a first down leg, the market is now working on a second one. And this would be fully reflective of economic forces. For instance, financial earnings used to represent some 40% earnings (if you count the financing arms of some old line “industrial” companies such as General Electric and General Motors). Thus, they made up $32 of what used to be normalized S& P earnings of $80. But most of those financial earnings have disappeared. That, by itself, would take the S&P earnings into the $50s... But how many of those non-financial earnings (of $48) were tied to the finance bubbles such as the homebuilding and the “housing ATM?” At least 10%, or around $5, and that's being conservative. Thus, normalized S&P earnings are likely to be no more $50 a share, if that.
The problem comes at payback time. For instance, much of the borrowing was tied to the housing market, on the bogus theory that houses could be made twice as valuable (as a multiple of rent) as they were for all of American history if prices could be kept on steady incline. The problem was that valuations collapsed when house prices fell, or even failed to rise, bringing down the market with it. To make up the shortfall, the U.S. economy now has to consume less than it produces, for a time. But the formerly virtuous circle became a vicious circle when falling prices (and consumption) led to falling production in a self-reinforcing process of the kind best described by George Soros in the Alchemy of Finance. This is a process called under absorption, which in its strongest form is called disintermediation. When a major part of the economy becomes “unstuck, the rest of it doesn’t merely go into retrograde. It has to fall apart also to keep pace.
But I can live with $50 trough earnings, say many. And at historical multiple of 14-16 times trough earnings, the S&P should stop its downside in the 700-800 range. But the point is, they’re not trough earnings, they are the “new normal.” And in the current “slow” (zero or worse) growth environment, a trough P/E of 6-8 times earnings is more likely. Put another way, we are about to get the worst of all worlds; below trend earnings, below trend growth from a depressed base, and below trend P/E, after having gotten the best of all worlds, astronomical P/Es on above-trend and rapidly growing earnings, about a decade ago. Warren Buffett now agrees, saying that we will get “almost the worst of all possible worlds…”
The bears-turned-bulls have taken the latter stance because the market now reflects at least a severe recession. One such commentator likened the recent market to 1938-1939, and feels that the latter represents a bottom. But the 1930s bottom was 1932, not 1939, which is to say that the market has further to fall. Having correctly dodged the “overvaluation” bullet earlier, the new bulls pin their hopes on the prospect that the current market represents everything bad short of the 1930s Depression. Unlike us, they aren’t willing to grasp the nettle that the current crisis will likely be as bad as anything including the Great Depression.
© 2009 Thomas P. Au
Thomas P. Au, CFA | Author & Market Analyst, R. W. Wentworth | New York City, NY | Email