November 2008 |
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As we look out over the valley, we realize that we're still afraid of heights. This is not a congenital fear. We'll be happy to invest in stocks again and we will gladly stare risk in the eye. We're looking forward to that day. It will be a time of great opportunity for making money again and making money is fun. Still, as we've been saying for some time, accepting risk in the face of real-live negative consequences rules our thoughts.
Over the last eight trading days, the stock market is up about 18%. Instead of being off 44% from its high, the market is now only off 34%. This rally has reduced the required gain to break-even from a daunting 80% to a still daunting 50%. Such is the depressing math of bear market losses.
We believe this recent recovery is a classic "relief rally". For many investors, it is a huge relief to see that the stock market can go up, not just down!
What is also classic about relief rallies is the predictable chorus of people ready to call the last market low "the bottom". Today is no different. And as any humble investment manager should do, we listen to their arguments in order to test and retest our positioning.
Basically, the arguments range from "Hey, this market was down almost 50% and that's got to be enough, right?!" to "Things are far way too negative, the market must have priced in the recession already, right?!" I would call these types of arguments as sentiment-based.
Admittedly, sentiment matters as a contrarian indicator. Investor sentiment was really, really low. Often, overly negative sentiment indicates a market ready to bounce. This rally was not a surprise to us. We consciously chose not to play the guessing game by trying to pick exactly the right time to get in.
Another category of arguments that we've heard are more value-based in nature.
While analysts who follow individual companies still have ridiculously high expectations for 2009 earnings, the top-down market strategist have already slashed their view of 2009's prospects.
It is a well-known fact that earnings are going to be much lower than the record set in 2007. Investors who want to be bullish point to this widely held recognition as evidence that the market has already "priced in the bad news".
This advice is so common during bear markets that Wall Street has great sayings to describe the phenomenon. If it's priced in, then why worry about 2009? Instead, it is wise to look to the recovery in 2010 and beyond. Investors should just "look over the valley". Stocks will "climb the wall of worry".
Beyond the old sayings, the industry does use facts and figures to back up the advice to buy now. We actually like looking at facts and figures.
Record earnings, based on the best trailing 12 months that ended in June 2007, reached $90 per share. When we measure earnings growth from the previous earnings low set in March 2003, earnings were able to grow at a 17% per year clip. This was truly astounding growth in corporate earnings. No wonder the stock market rose considerably during that '03 to '07 stretch.
Back in March 2003, investors were willing to pay about $17 for every $1 of earnings. Historically, bull markets don't start with such high price-earnings multiples. As many know, we were skeptical then too.
But, to our surprise, paying 17x earnings didn't kill off future returns for investors after all as the earnings growth during the economic recovery was robust, to say the least.
Now, in order for investors to enjoy the full effect of that remarkable earnings growth, investors had to sustain their desire to pay a high $17 for each $1 of earnings. They did and all the earnings growth was then theirs' to keep. It doesn't always work out that way.
However, since the market peaked about a year ago, earnings expectations have crumbled. The consensus estimates for 2009 earnings range from about $50 to $70. If we simply picked the mid-point of $60, earnings are poised to fall about 30% from their record levels. Recessions have that effect as the peak-to-trough earnings declines after the '91 and '01 recessions show.
First off, our concern is that the decline in earnings could fall at least 30% when all is said and done. It could be more considering that earnings records in 2007 came by way of the credit-enhanced US consumer. It is kind of like discounting the validity of Barry Bond's steroid-induced homerun record. Unemployment is rising and consumer credit is contracting. There could be major earnings disappointment at least through next year and even into 2010.
We feel the consumer has "reached the end of the moving walk", so to speak. They are going to be required to power their own way forward and that means they will have to work, sacrifice and, yes, save money. Things are going to be different, in our opinion. The credit bubble has burst.
As a result, the anticipated recovery may not be a typical recovery at all.
It may be that we're simply pushing the "reset" button on our economy. A snap-back effect like we felt in past recessions may not save the day. The valley may be deeper and longer and the wall might be higher than investors now believe.
If the recovery is slower and choppier than previous recoveries, it is probably unreasonable to have to pay $17 for each $1 in earnings. It would be more reasonable to pay $13 or $12 or $10. Past market lows have started even below these levels.
The lower the future growth the lower the price an investor is willing to pay for it. The only sure way to get the returns you deserve is to demand a price that compensates for nasty surprises.
At today's multiples, there remains real risk of additional losses before we reach the real bottom. Remember, this business contains a lot of guessing. However, it is purpose-driven guessing.
If we are right, the pain that is still to come, after this classic relief rally, could very well shake investor confidence again.
With that, we could see the kind of capitulation that marks the moment that we'd gleefully get to work in buying stocks again. We look forward to it.