Detoxing the Markets: Bears Still Look Hungry

Source: www.thestreet.com ^ | 07/16/2002 | By Peter Eavis

[Lazamataz]

Capitulation, my foot.

Monday's trading may have created one of the most gut-wrenching days in stock market history, but it hasn't brought equity values to a bottom. A broad market index like the S&P 500 must slide another 20% or more from here before it is properly valued. Chillingly, even after this year's 30% drubbing, tech stocks must lose half their current value to reach sensible levels.

other words, the S&P and the Nasdaq will both need to drop to around 700 before stocks hit a floor. The one piece of good news is that we're in the last leg of the postbubble correction. But as all action-movie fans know, the last sequence is always the bloodiest. The end is nigh, but it is also in sight. The bad guys in this story are yet to be slain: nosebleed valuations, earnings tampering and a hamstrung macro environment.

(One big caveat: Despite the bleakness of the last few days, stocks almost certainly won't go straight down from here. Recall how long it took for the Nasdaq to hit Detox's target of 1500.)

Despite the selling, a substantial reserve of bullishness still exists on the Street. A clear sign of that is onetime bears like Bank of America's Tom McManus telling people to buy more stocks. Meanwhile, the Fed's monetary policy is extremely loose, and that is keeping the financial system intact -- at least for now. And the selling surely won't be done until we stop hearing the idiotic mantra that equities are cheap because they've fallen so far. On that yardstick, Adelphia, Enron and WorldCom are all screaming buys.

Fundamentals drive markets over the long term, and they still bode ill. Don't be tricked by the argument that because we're trading at close to 15 times expected 2002 earnings for the S&P 500 companies, we must be close to a bottom. Fifteen times is close to the long-term average multiple for the index.

Yes, the index is trading at around 18 times the $51.14 of forecast operating profits. And yes, these may be trough earnings for some sectors. But why are forecast as-reported earnings -- that is, earnings after certain charges and supposedly nonrecurring items -- so much lower at $35.47?

Some of the gap has to do with thedifferent ways that S&P collects as-reported and operating earnings,but it is also because operating earnings generally leaveout goodwill writedowns that have been necessitated by the introduction of a new accounting rule.

Now, there is some argument for keeping a chunk of those writedowns out. But these won't be the last goodwill writedowns we see; as accountants are forced to do their jobs properly, such charges to intangible assets are likely to become a lot more regular. Quite right, these may not be cash charges, but in most cases it took cash to buy or build those assets in the first place.

For those reasons, it makes sense to factor in some of the goodwill charges. Very roughly, that could be done by taking a midpoint between as-reported earnings and operating earnings. That gets us to around $43 in S&P 500 forecast 2002 earnings. Multiplying that by the 15 multiple makes 645 -- close enough to Detox's 700 target for the index.

At the same time, tech stocks have to continue tanking. If we use the S&P 500's information technology sector index as a rough yardstick for tech names, the sector is trading at an absurd 38 times forecast 2002 operating earnings. If we halve that multiple to 20 times, that sector index must also fall by 50%, all else being equal. And 20 times is an aggressive valuation for a sector that is crawling out of one of the biggest busts in history. Apply the halving principle to the Nasdaq and you're at 700 once again.

Of course, any discussion based on earnings assumes we can trust the profits numbers that are reported. As we have seen, that's about as advisable as letting Hannibal Lecter babysit your firstborn. The bulls will retort that once the SEC's deadline passes this fall for CEOs to pledge that their company's numbers are clean, the market will be able to rally.

But who's to say the liars won't keep lying? The wording of the pledge is loose enough to let a top dog weasel his way out if chicanery is exposed later. And even if generally accepted accounting principles are adhered to, the stuff called earnings may bear little relation to what is generally thought to be profits. Actually, it's not even clear that professional money managers know what profits are, given the extent to which postmodern blurriness has infected institutional investors. It's quite mystifying why the head of, say, the Janus Twenty fund hasn't been dragged before Congress for losing billions in mom and pop money. Why the brokers and the accountants and not the people who actually destroyed the wealth?

Completing the nightmare, the Fed can do little more and is looking more and more like the Bank of Japan each day. It has cut rates like crazy and unleashed an unprecedented credit boom -- even in the midst of an economic slowdown, a phenomenon few economists can explain. But this lending bingewon't offer much lasting help, because all it has done is inflate prices in the housing and services sector, shore up demand for autos and make it much easier for the government to suddenly run up a huge deficit. All those uses are consumptive and divert resources from productivity-enhancing investment. What's more, firms are too debt-laden to go back to '90s-level investment spending.

As Alan Greenspan massively raises the supply of dollars, the greenback's price -- surprise, surprise -- is falling against other currencies and gold. It's easy to see why foreigners are heading for the exits: First, in this postbubble, overleveraged environment, the opportunity for good returns has diminished. Moreover, the Fed is deliberately cheapening the dollar that the outsider eventually aims to get paid back in.

But the domestic investor has stayed relatively faithful. Sure, individual flows into the market are way down, but mutual fund flows are still strong, in large part because of the captive 401(k) flows. A reversal of those flows will be the next shoe to drop. And it will trample stocks still further. Capitulation means surrender. And the bears can still safely cry: "No surrender!" Even after a day like Monday.

[FITZ]

I think people used to invest in the stock market by looking for companies to invest in over a long term ---but now it seems like it's more a day-to-day or hour-by-hour, watching the graphs to see when they might peak and everyone sells, then they watch to see when they might bottom out and everyone runs out to buy.

[steveegg]

Cha-ching! I needed that laugh.

[steveegg]

Not quite how I define subtle, but it works. Personally, when I am subtle, that 2x4 heads to the back of the head (I like the element of surprise).

[steveegg]

You nailed it. There's nothing like instant widespread communication.

[ken5050]

At a party, this drop dead gorgeous woman walks up to a very important CEO, and says to him, in a very sexy voice...."I'll do anything you want..absolutely anything."

He replies.."reprice my stock options."

[Willie Green]

To me, subtlety is a two-by-four into the face.
Not-subtle is when you swing it so that the 3" two-penny nail imbedded therein sticks out.

Laziness is repetition of quips that you've used before.
You used to be much more creative than that.
Must be slowing down in your old age.

[Southack]

Sure, the money supply has increased, but how fast has it increased compared to our rate of growth?

The whole reason that we got off of the Gold standard was so that we could make our money supply increase as fast as our economy needed capital.

Without enough capital, the economy stalls.

Our economy hasn't stalled, much less stalled from a lack of capital.

Our stock market, on the other hand, has been over-priced for 7 years. That's almost biblical. 7 years of stock-market-boom followed by ... of stock market bust.

In the meantime, Joe Averages around the country continue working and living paycheck to paycheck, dutifully producing and consuming. Joe's gonna be a bit pissed when he figures out that his 401(k) retirement fund is knocked back to 1994 levels, of course, but he's still gonna make his car payment, house payment, alimony payment, and buy beer for the big game.

[steveegg]

Nah; it's all the humidity in the air up here in the Midwest.

[RightWhale]

Looking at GM's latest dividend, it appears to be 50 cents on a stock of about $50 per share. If the dividend is quarterly, that amounts to a 4% annual return on investment. GM is paying a dividend; many other comapanies pay less or none at all. Bonds do better, some even twice as well, although muni nontaxable pay 50% more. Stock price of GM could drop to 2/3 to half its present level to achieve parity with bond return. DJIA could end up 4500 to 6000 if all the stocks were as good as GM. This would assume that stock prices are going to stay at that level and get-rich-quicker people don't bid them up again.

[steveegg]

Er, isn't that 8 years back to '94? Seriously, provided that the Cooked Book disease is limited to the companies that have been caught, the market should be at bottom now. The previous bottom was in '91, which, in a non-politicized market would have made the next botton in '98, with that bottom being at early-'97 or late-'96 levels. We're in '97 territory now.

Of course, I am assuming that (a) there are no more Enrons and (b) the goverment won't use this as an excuse to interfere. If either of these happen, I can't guarantee that the ultimate bottom of 0 won't be reached.

[Tauzero]

Last I looked M3 was flat.

[Tauzero]

How much of the latest increase is commercial paper?

[Tauzero]

"Inflation will occur if they keep this up, as well. I am shocked it hasn't!"

What do you think the 90s bull market was?

When newly-minted dollars push up the price of bread and gasoline, the government calls that inflation. When newly-minted dollars push up the price of stocks, why, that's a bull market!

[Southack]

It's always hard to call the bottom, but I'd guess that we're not there yet.

For one thing, mututal funds are just now beginning to get real quantities of sell orders. For another, we're going to see almost all of the Fortune 1000 companies restate their earnings between now and August 14 to comply with the new accounting rules in place.

On top of that fact, August is historically a bad (possibly the worst) month for stocks.

I feel safe in stating that there is no realistic chance of turning the corner on the bottom prior to a patriotic rally on/near 9/11/02, and even that could prove to be a sucker's rally if the disclosures that come out prior to that are too extreme.

If you have to be long in the Market, get thee to a high-dividend, stable earnings stock. Otherwise, you'd probably beat most professionals simply by sitting on cash for the next two or more months.

[qwertyz]

Do you mean the velocity of money is still low?

[habs4ever]

I'll go over to the St Louis Fed page and check.It certainly has improved since last October.

[Southack]

Isn't "velocity of money" just the speed that money changes hands?

We should be constantly setting new record highs for that here in the U.S.

[Dog Gone]

Sure, the money supply has increased, but how fast has it increased compared to our rate of growth?

I don't know, but looking at that graph, it certainly appears to me that that the money supply was increasing even during the recession.

I'm not even sure it's a bad policy. The strong dollar made vacations to Europe affordable, but it had drawbacks. A weaker dollar stimulates those portions of the economy, like exports, that could use a good stimulus.

Monetary policy is an inexact science at best, but you rarely hear it explained in blunt terms. Alan Greenspan ought to say, "I'm increasing the number of dollars in this economy, because I want to stimulate some demand for goods and to weaken it against foreign currencies. If the Japanese don't like it, tough."

[Dog Gone]

How much of the latest increase is commercial paper?

I don't know, but the M1 and M2 measures show a similar trend.

[Southack]

Well, in my opinion the Japanese aren't complaining about us weakening our Dollar because they are likewise over-printing Yen right along with us.

Europe wants a strong Euro for prestige, but it will kill their exports and make our goods and services far too competitive for their fragile corporations to compete with. In my opinion, the Europeans think that increasing the value of the Euro will give them a political position of power and prestige that is worth the cost to their economy. I also think that they are suckers for behaving that way. The whole world would be better off with three strong economies (EU/Japan-Asia/US) instead of just two, but at least we won't be the ones on the losing end of that game.

A cheap Dollar means that people will be selling foreign assets and bringing those profits home. It means that we'll import a little less and export a little more. And since oil is traded in Dollars, our main import won't be impacted by what would otherwise be inflation.

Mmm... Just what the doctor ordered.