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
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 downleg, 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 is 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 underabsorption, 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 probably 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.
