Markets Unplugged

The sucker rally

The US S&P500 stockmarket index closed on Friday at 890 – 20% higher than it’s low set on 21st November ’08, and the current rally has been a cause for great optimism amongst some investors. ‘The worst is over’ or ‘stocks are cheap, get in now!’ is what some people may have you believe. Since the US is the engine of growth that drives the world, if they start to do well, then so will NZ and the rest of the world will surely follow. The NZX50 closed on Friday at 2757 – a mere 7% off the Nov 21 ’08 low of 2568, the rally in NZ has not been as pronounced. The NZX50 at it’s lowest point last November was some 40% off it’s 2007 highs, a staggering fall in little over a year.

How do we measure “cheapness”?

After such staggering falls in the stockmarket many people have started wondering that if stocks are so cheap, is now the time to buy? Well that all depends on how you value a stock, and one could also argue that stocks were previously overpriced, and they are just correcting back to more “normal” levels. In the stockmarket, the most common way of valuing how expensive a stock is – is through it’s price-to-earnings (P/E) ratio. The average P/E ratio for the S&P500 over all time is 15 – anything above this value and stocks are more expensive on a historical basis, anything below 15, and stocks are historically “cheap”. The P/E ratio has varied hugely over time, from it’s highs at the peak of the dot-com mania in the year 2000 of 40, to lows below 10 at the end of the worst bear markets in history in 1921, 1932, 1949 and 1982 – and we are currently in one of the worst bear markets in history.

So are stocks really cheap right now?

Focusing on the US markets for now, the closing price on Friday for the S&P500 was 890, and the Earnings Per Share for 2008 was $48 which gives us a P/E ratio of 18.5 as the market currently stands. Not by any measure is that cheap, in fact it is well above the long-run average of 15. What has happened is that although the stockmarket has fallen, corporate earnings have fallen significantly also, so the P/E ratio has not come down as quickly as might be expected. We are in a secular bear market that began with the popping of the dot-com bubble in 2000 – and secular bear markets have historically ended with a P/E ratio below 10. That would mean that if corporate earnings stayed constant in 2009, the S&P500 would have to fall to 468 – a further 47% from today’s levels to give us a P/E ratio of 10. What is most likely to happen however, given the global recession, is that corporate earnings will fall again in 2009, which is rather scary given that this would mean that the market would need to fall even further to achieve the P/E ratio of 10 that we are talking about. The bottom line is that what looks cheap now could potentially get a lot cheaper!

Is it all doom and gloom?

The world will not end and corporate earnings along with the stockmarket and economy in general will eventually recover. When this will happen in unknowable and we can only look to the past to give us some benchmark, but bearing in mind that the past is only a guide to the future, nobody has a perfect crystal ball, not even George Soros or Warren Buffet. But in the meantime, just be wary of anyone trying to tell you that “stocks are cheap”. There are going to be plenty of tradeable rallies in this bear market before it ends. There is no reason to not participate in the rallies, just be wary that volatility will be high, and it is probably wise to avoid leveraging. Watch your positions so that if the market turns sour, you are ready move into cash.

Good luck and happy trading for 2009!

Was the rally in the US markets last week the beginning of a new trend upwards or just a temporary “dead cat bounce“? Let’s take a look at the facts.

In the past week the S&P500 index rallied up a staggering 20% from it’s low of 741 set on the 21st November. In my last post I wrote about the extreme levels of Volatilility we were seeing – with the CBOE VIX at at record high of 80, and how sometimes this marked a short or long term low in the market. Well it seems now that we did indeed get a bounce, and the market closed on Friday at 896, after one of the biggest ever up-weeks in history. Volatility is still very high and as such we are seeing a lot of records being set at present.

However the market still remains in a clear down-trend and well below the 50-day moving average line. The last time the market rallied was around the US election time, where it rose from it’s low of 825 to 1007 (a 19% gain over the course of one week) before resuming it’s downward slide. The “Obama bounce” is it was dubbed was attributed to the euphoria and optimism that is normally seen around US elections and especially with a new President being elected. After it had all died down, reality set in and the market resumed it’s downward plunge.

In the past week there has been some “good” news come out. The US government has bailed out Citigroup to the tune of $306 billion. There was the unveiling of Obama’s economic team of super-stars, and an $800 billion plan for getting credit flowing again in the financial markets. The bottom line is that the US government is throwing everything they have at the markets, by continually pumping cash into the system and bailing out “too big to fail” institutions. But it’s prudent to remember, that they have been doing this since early this year, beginning with Bear Sterns, and yet that has not been enough to stem the downward slide in the equities markets. When will enough be enough, remains to be seen.

Alongside the good news there was plenty of bad news as well. The fundamentals of the US economy still look dire, Q3 GDP revised downwards to -0.5% from -0.3%, durable orders down 6.2%, existing home sales down 3.1%, new home sales dropped 5.3% and consumer personal spending down 1.0%. Not to mention the London based BlueBay hedge fund’s closure of it’s emerging markets fund after it lost 53% of it’s value since September, and the NY based Satellite Asset Management stopped client withdrawals from it’s 3 largest funds. The interesting point to note here, is that a rallying market will tend to ignore bad news and focus only on good news.

From a technical point of view it was interesting to note that the volume was very much down last week, which calls the strength of the rally into question. Usually when a strong rally takes hold, it does so on increasing rather than declining volume. It is my belief that this rally is simply a “dead cat bounce“. The fundamentals of the ecomomy paint the true picture – the US economy is shrinking, and in an environment where GDP is shrinking one would expect that corporate profits are going to also shrink. If corporate profits shrink then prices of equities must fall to maintain a constant P/E ratio (that is assuming that investors do not all of a sudden decide to accept a higher risk premium).

The only wild card is what is known as the “Santa Claus” rally effect where fund managers try to bolster stock prices at year-end to make their yearly funds’ performances look rosier. I expect the market to start selling off again in the new year and to remain in a downtrend until some uptick in consumer prices and corporate profits shows up. In the meantime, expect Volatility, and lots of it!

It has been done…… the markets made history yesterday as the S&P500 broke the September 2002 lows of the tech-wreck bear market. If anyone wanted any hard evidence that this bear market is going to be the far worse than the last one, and far worse than anything we’ve seen in our lifetimes, yesterday provided the hard cold evidence. The market is now 50% down from it’s peak in October 2007.

The CBOE VIX (Volatility Index) which is a measure of investors’ fear (known as the “Fear Gage”), made a record yesterday as it hit an all-time high of 80 – to put this into perspective, since the start of the index, the highest it had ever reached before was in August 1998 (the Asian Financial crisis) where it hit 44.28 and then again in September 2002 at the bottom of the bear market it reached a high of 39.69.

The VIX is a measure of volatility and a measure of the risk premium that option contracts writers’ demand – the higher the premiums, the higher the level of risk that is perceived by the market. So not only are we making records, we are completely smashing them. It is interesting to note that in the past these highs in the VIX have marked the bottom of the market, it remains to be seen whether we are at the bottom, or is the VIX simply going to keep spiking higher and higher as the market plunges to fresh low after fresh low? Obviously since nobody has a crystal ball no-one can give that answer.

The S&P500 yesterday finished at 752. To put that into perspective, a level below 780 puts the market into the lowest 20% of all historical valuations. The 700 level on the S&P500 puts the market in the lowest 10% of historical valuations, and a further decline to 625 would be the lowest 5% of valuations. Anything below 600 puts the market in the lowest 1% of all valuations.

It is my belief that since this crisis is unlike anything that we have seen in our lifetimes, and argualbly we are in much worse shape than 2000-2002 dot-com bust and the 1970s inflationary recession, we could very likely see the market make lows that put it into the top 5% or top 1% of (lowest) valuations. This means that the S&P500 will get below 700 and test 600 in the coming year. There are just so many records being set and that have already been set, the highest number of hedge-funds ever, the highest ever house-price-to-earnings ratios, the greatest levels of debt per household ever in the Western world. All this debt and leverage needs to be unwound, and that is what we are witnessing, the greatest unwinding in history.

There has to be a lot of investors at present sitting on the sidelines and thinking, gee, stocks are looking really cheap. At some stage this will result in a bear market rally (as these investors pile in), but it remains to be seen when, and if it happens, if it can stick. In the meantime I intend to keep watching the market action closely, because we are on the verge of the greatest investment opportunity of our lifetimes. We are unlikely to see a period of time again in the next 20-30 years when valuations of stocks will be so low. Interesting times!