Monday, August 9, 2010

Fearing the Bear, but Who Knows Where and When?

The stock market feels a bit like the economy- creepy if one looks at the linked chart and clicks on the 5 yr button. My interest is in the July 2007 period till now on the 10 year bond.

What my eye sees is a steady downtrend in rates with some variations from trend: the initial accelerated drop in rates in the second half of 2007 related to the sudden Fed moves, then the post-Lehman collapse in rates at the end of 2008, and the overshoot upward in rates this year just as various economic indicators proved to be peaking or to have peaked.

Bill Gross is looking at ZIRP through perhaps 2013, which is to say (scream): Japan! Japan! Japan! (Sort of the opposite of Tora! Tora! Tora!)

And Consumer Metrics, which claims to lead GDP by 1-2 quarters, just reported that July was so bad that only one month in the 2008-9 cycle was worse; and just by a smidgen. Even worse, CM's average reading for the first 7 days of August is more than a point below that lowest level in the Great Recession (assuming it is over), which occurred in August 2008.

And we all know what happened to stocks beginning late in August 2008 and thereafter.

I feel about stocks on trend, though not in degree, the way Nassim Taleb says he felt about Fannie and Freddie when he was shown a balance sheet analysis of them in, perhaps, 2001 or so. He recounts that he predicted disaster, but had no idea when that would occur. He just thought they were risky and way overvalued.

My sense on stocks is not that the market goes to zero the way a 100:1 leveraged mortgage company can go to zero, but rather that the stock market is over-promoted and that far too many companies that are called "blue chips" in fact have no, or negative, tangible book value. This is a result of stock buybacks, debt-based acquisitions, various accounting maneuvers, and of course value that does not appear on the balance sheet. But the beauty of Smithers' analysis is that he considers both earnings and tangible asset values. These usually agree, and now each is suggesting that the S&P 500 is about 50% overvalued.

In other words, pros know that earnings are only one of several ways to value companies, but CNBC et al focus almost exclusively on a non-GAAP measure of earnings called "operating earnings", which as you know means whatever a company wants it to mean. Let's say business shrinks for a product line and a production facility must be closed ahead of schedule. The company will say that's not a normal cost of doing business and try to exclude it from the public's evaluation of its earnings. But those unpredictable downside costs are just as valid as the occasional earnings beat because customers double-ordered due to fears of a product shortage!

Because it's not easy for either of Smithers' measures (q and CAPE) to change fast, the way the stock market can get to his view of fair value within the next several years can only be by declining. There is really no other way. Now it may never get to fair value, of course, but on the other hand a sober view of his chart shows that overvaluation periods have alternated with undervaluation periods.

I invest based in good measure on the principle of reversion to the mean, though looking at momentum and fundamental factors as well. But I believe that one should never ever fight the principle of mean reversion.

For stocks and the real economy, there is unfortunatley no New New Thing; war seemingly without end in Asia continues; most important recent IPOs have been of Chinese companies it would seem; and for the most part the average stock or index fund just allows one a powerless, tiny minority share in companies that care about their insiders before they care about their public stockholders.

And if states and the Federal government actually balanced their budgets, either by spending cuts or tax increases, what would happen to corporate profits???

Given that no one can answer that question (which of course is wildly theoretical), the entire economy and therefore the valuation of stocks is based on more speculation than usual. To value stocks on the basis of zero short-term cost of money is crazy, as we know from Japan that chronic ZIRP has led to numerous stocks selling well under tangible book and for less than quick liquidating value; and their stock market now yields far more than their 10-year government bond. Meanwhile our 10-year still yields about 40% more than the S&P 500 as a whole.

All this is with the backdrop in which the financial class that has been treated so well by the government the past many years moans about "deflation" and somehow thinks the central bank of the United States can make their lives even better than they are now while every survey of real people shows that the recession/depression continues.

What I'd rather do than buy the stock market when it is priced for a boom when there is actually the opposite of a boom going on is to buy stocks after chronically depressed economic times have persisted when stocks are priced for said bad times to continue. Think 1921, 1948, 1982 (see Smithers' chart). Not 2010.

In my opinion, one has to be very quick and agile to gather rosebuds from buying into this stock market. Too many thorns . . .

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