Posted on 08/06/2007 12:51:02 PM PDT by SirLinksalot
It doesn't take much when you're near the tipping point. Last week Countrywide Financial said it had increased defaults on some of its home equity loans and several banks took unexpected charges against potential credit defaults. Suddenly investors reacted as if the whole world had changed. Their fears sent the popular stock averages to their biggest loss in almost five years and the bears proclaimed that the days of easy credit that has fed the bull market over the past 4 ½ years were finally over.
Valuations are Sound
But the purveyors of doom and gloom are wrong. It's true that over the past few years the interest rate spreads between the high and low-rated debt became extremely low by historical standards. Then tremors developed last February when the sub-prime mortgage crisis surfaced. These tremors turned into an earthquake last week when the private equity firms and banks wanting to acquire Chrysler and Alliance Boots failed to attract the lenders needed to finance their $20 billion buyout. All of a sudden, the stock market bears emerged from hibernation to yelp "I told you so!"
But the bull market in equities did not depend on these low spreads or on the rising tide of leveraged buyouts. Despite the fizz in a few stocks, the overall level of the stock market never became overpriced relative to the most fundamental metric of firm value - corporate earnings.
Based on the S&P 500 Index, which constitutes 80% of the total market value of U.S. stocks, these stocks are now selling at 16.5 times a conservative estimate of 2007 earnings. In a world where government rates are below 5% and inflation is below 3%, stocks are not only reasonably priced, but cheap on a historical basis.
Positives for the Equity Market
But valuation is not the only reason to stay invested in stocks. The following facts are also very positive for equities:
(1) Although there was a sharp increase in the interest rate on low-grade debt securities, there was little if any increase in interest rates on investment grade securities, which constitute the vast majority stocks in S&P 500. This is because the increase in the spread between investment-grade bonds and the Treasury yields was more than offset by the drop in U.S. treasury yields, so credit costs for quality stocks have not increased.
(2) Although the housing market remains in the tank - and will stay there for quite a while - there is still no convincing evidence that the rest of the economy is headed for a significant slowdown and certainly there are no signs of a recession. Second quarter GDP grew at 3.4% rate despite a lousy housing market. Early estimates for this quarter are for 2.5% to 3% growth. This would be greater than the slow growth of the first half of the year during which time corporate earnings still rose briskly.
(3) In a worst-case scenario where the tightening of credit standards does lead to a substantial economic slowdown, the Fed has ample room to ease interest rates from the current 5.25% level. With the sharp drop in treasury yields across the board, the term structure of interest rates has once again become inverted, with the ten-year bond falling to 4.75%. This puts the central bank on alert that the market thinks that short term rates may be too high. In fact, the Federal funds futures market now expects two 25 basis point reductions in the Federal funds rate by next summer. Although I think the economy will stay strong enough so that the Fed will not have to lower rates, if the Fed does act, this will be very positive for stocks.
(4) A large part of the stock decline last week was due to portfolio managers establishing defensive positions by buying index puts to protect themselves against market declines. The VIX index, which measures the premium that investors pay for such puts reached 24, the highest level since the start of the Iraq war 4 ½ years ago. Spikes in this index have historically been great times for investors to buy stocks.
(5) It will be several months before we find out how hedge funds faired during this turmoil. If their returns suffered, this could ultimately be very good for stocks. Hundreds of billions of dollars have migrated from the equity markets to "alternative investments" in recent years. If these alternatives fail, it is very likely that much of this money will return to the equity market.
What Should Investors Do?
The strategy for investors is clear. The cost of credit has not gone up to the top credit companies - such as those rated A and B by Standard and Poor's. It is the lower-rated firms, as well as many smaller stocks that have do not have a ready access to the credit markets that will be hurt the most if spreads remain wider. Those lower rated stocks have had a wonderful ride for the last several years, but that ride is over. Quality stocks are set to outperform the market and withstand the credit storms.
Is there anything to worry about? Sure. Oil prices continue to rise in spite of the declarations of Kuwaiti officials who said they would like to see crude oil back in the $60 range. If oil and its derivatives - gasoline and heating oil - keep marching upward, this will crimp consumer spending and slow the economy.
But, history tells us that the worst time to buy is when there are no clouds on the horizon and everyone is optimistic. On the other hand, the best times for stocks are when there are mountains of worries. Despite the scary headlines, the underpinnings of our economy and stock market remain strong. Rotate to quality stocks and you will weather the storm well.
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Jeremy Siegel, currently the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, has written and lectured extensively about the economy and financial markets.
He has appeared frequently on CNN, CNBC, NPR, and others networks. He is a regular columnist for Kiplinger's and has contributed to the Wall Street Journal, Barron's, Financial Times, and other national and international news media.
Siegel is the author of two books, "Stocks for the Long Run" -- named by James Glassman of the Washington Post as one of the 10-best investment books of all time -- and "The Future for Investors." He taught for four years at the Graduate School of Business of the University of Chicago before joining the Wharton faculty in 1976. He served for 15 years as head of economics training at JP Morgan, since 1988 as academic director of the U.S. Securities Institute, and is currently Senior Investment Strategy Advisor to Wisdom Tree Investments.
In May 2005, Siegel was presented the Nicholas Molodovsky Award by the Chartered Financial Analysts Institute to "those individuals who have made outstanding contributions of such significance as to change the direction of the profession and to raise it to higher standards of accomplishment." Other awards include the Peter Bernstein and Frank Fabozzi Award for the best article published in The Journal of Portfolio Management in 2000.
Siegel graduated from Columbia University in 1967, received his Ph.D. in Economics from the Massachusetts Institute of Technology in 1971, and spent one year as a National Science Foundation Post-Doctoral Fellow at Harvard University.
Oddly, today’s market was lead by mortgage companies, brokers, and home builders. Tech and military and oil companies tanked. I just don’t understand it right now.
short oil etfs...consumer less $$$, China less demand for oil...
Market up 286 today. Just going up and down to find a plateau and will move up from there.
This guy has a PhD and can't spell "fared". Oh, well...I guess his strength is economics.
I agree with him on that.
Emotion is a contrarian indicator.
If it feels good, don't do it. If it feels bad...load up.
Not that odd.
They just had a large correction last week. Today is recovery.
You are attempting to apply logic to the market????
Market is long term investment, don’t attempt to apply logic to it.
I am waiting several months and buying some great foreclosed homes in the winter of 2008 and renting them out. Real Estate going to still be the best investment over stock returns over the next decade in my humble opinion.
How to play the market sell-off...
whoops!
How to play a bull market...
Whoops!
How to play a...
etc., etc., etc.
You think they have advanced spelling courses as part of the PhD program?
Oil was down $6 from last week and gasoline down 10 cents today. Everybody shifted into financials, which had declined considerably last week.
Oil was down $6 from last week and gasoline down 10 cents today. Everybody shifted into financials, which had declined considerably last week.
“You think they have advanced spelling courses as part of the PhD program?”
Them as gets PhDs shoulda lernt howta rite good bye thn.
China is growing 10-20% per year. What force of nature allows them to use less oil. Inquiring minds want to know....
His strength definitely IS in economics. Both his books are excellent long-term studies of the financial markets.
Study his book "Stocks for the Long Run".
Between the lead paint and contaminated food scares, I would be more concerned about selling off my China stocks than my US stocks. If Americans quit buying Chinese goods, their economy will collapse around them (they have a much more significant building bubble than even we have at the moment). They assume a massive increase in exports every year, but what if their imports were flat because people were afraid to buy Chinese or the American economy were to really slump (by which I mean a real recession, not this “miserable” 3% growth with the “outrageously high” 4.6% unemployment)? I think international markets have more to fear from a Chinese collapse than an American recession (even if the recession causes the collapse). If you wonder what a Chinese collapse would look like, look back at the collapse of the economies of the "Asisan Tigers" in the 1990s. The resulting fall in oil prices as Chinese demand abates, however, would be very good news for us.
The author of the cited article is right about valuations. The earnings of export-oriented companies and corporations with significant operations overseas (not in China) are destined to grow even more in the coming months, as the weak dollar makes US exports more attractive to Europe and Asia and favorable exchange rates make overseas earnings more significant on multinational balance sheets. Look at Boeing as an example: not only did they choose the right strategy in relation to design of the 787, but the weak dollar has allowed them to undersell Airbus significantly. I think it is time to buy, not sell.
You might sell your stock in large home-builders. They’re going to be hurting for a while (but I might buy in 6 months when they are cheap, as I see no sign we will ever control immigration significantly enough to lessen the demand for new housing).
By the way, my stock market advise is worth exactly what you paid for it.
Just a guess, but...
Non existent enviro regulations, refineries out the ying-yang, and sweetheart deals from Iran and Venezuela.
P.S. that doesn’t address the issue of less oil since their appetite for it is growing. But it does explain how the higher prices are not affecting them to the extent that it does us.
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