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.

[Neets]

If you had bought $1000.00 worth of Nortel stock one year ago, it would now be worth $49.00.

With Enron, you would have $16.50 of the original $1,000.00.

With Worldcom, you would have less than $5.00 left.

If you had bought $1,000.00 worth of Budweiser (the beer, not the stock) one year ago, drank all the beer, then turned in the cans for the 10 cent deposit, you would have $214.00.

Based on the above, my current investment advice is to drink heavily and recycle.

[technochick99]

I agree. I don't think there's much to be gained from an average person watching the market on an hourly, or even daily, basis and trying to make sense of it. Perhaps some people are just a wee bit obsessive....

[Dog Gone]

Japan is not publicly complaining, but they are intervening in the currency market to keep the yen from rising above 115 yen to the dollar. The last thing they want is for their exports to us to be too expensive.

I don't think they can win the battle of the printing press, although they may try.

The only danger is that we may print more dollars than the goods we produce, which is inflationary, of course.

[habs4ever]

Shrewd advice!! Go long booze, short sleep ;-)

[.38sw]

And buy Budweiser. I own a few shares of Bud.

[Southack]

I agree, except that Japan should be running up inflation by turning their printing presses on High in order to make their exports cheaper and encourage people in Japan to invest rather than hoard their money as they are currently doing.

They still haven't figured out that it is the velocity of money that makes or breaks their prosperity.

Just as in South America where the super-rich hoard their money rather than cycle it, the low money-turnover-speed in Japan (among average Japanese citizens) is the cause of their continued economic doldrums.

But start running up just a little bit of inflation (not so much that people switch the currency on their savings), and then people either have to spend their money to "get something for it" or else they will lose the value of their money by sitting on it.

[Lazamataz]

I never claimed to be creative, just tedious and screechingly annoying.

[#3Fan]

Bears still chomping bump

I still have half my money in my 401k. I don't want to look.

[Moonman62]

This is on purpose. They are trying to devalue the dollar and reflate the price level in order to offset the deflationary devestation they themselves created with the "strong-dollar"/tight money policy. We need inflation just to get prices back where they should be.

I kind of have my doubts about that. First, while Greenspan is politically brilliant, he is economically clueless, and his role in the strong dollar was an unintended consequence of his war against economic growth and full employment. If it weren't for 911, Greenspan would still have a tight monetary policy to combat the mythical "wealth effect." Second, the weak dollar isn't just liquidity driven. It's also driven by investors seeing diminishing prospects for any sort of significant economic growth in the US. Third, consummate demand manager Bush wants a weak dollar so that farm exports can lead us to his idea of prosperity, I kid you not.

[Wyatt's Torch]

Not going to argue the last two because you are correct. For the first, for the last five years I felt the same way. But I think Greenspan has learned his lesson and informally re-adopted his old gold-price rule. I may be reaching but with the influx of cash over the last 9 months (huge spike and then withdrawal after 9-11) can't be coincidental. Perhaps I'm giving him too much credit and the Fed is only defending their 1.75% FF rate.

[steveegg]

You did notice my caveat about more Enrons showing up in the news. I strongly believe that to be the case, so we're well above bottom (Dow 4000, NASDAQ 600 and S&P 350 by mid-October, anyone?). I'm not going to say how many more Enrons it's going to take, only that I think there's that many out there.

FWIW, outside of my 401(k), which has a long way to go before I near retirement and is as diversified as it can be, I'm nowhere near this market, and if I had some spare money, it'd be waiting in a passbook account waiting for the November elections (it would get a pittance of a return, and I would still be able to pull it out in the event of market bottom being hit).

[steveegg]

Is today "digestion day" for the bears? The major indexes' futures (as reported by CNN, the only place I have been able to find the futures numbers) have the Dow up 87, NASDAQ up 17 and S&P up 9.

Uurp! <VBG>

[Lazamataz]

This is fun. Because I am not exposed in the market, besides a 401k that is not to be touched for 25 years or more, predicting the daily trends for me is kinda my version of Football or Horse Racing.

I think today might be a regroup day. Sharply higher open, then settling back down to middling levels.

Of course, these daily predictions are a hell of a lot less accurate than longer term ones.

[steveegg]

As long as I remember not to open my quarterly 401k mail, I'm all right. I usually stick with football (how are the Bears looking, BTW? :) , but since training camp isn't open yet,....

The bears will be back hungry tomorrow. It must be the Midwest air that causes us to think alike.

Who has the thread duties today? I don't have any good links, so I'm out.

[Lazamataz]

I usually stick with football (how are the Bears looking, BTW? :)

I don't do football.

I do stocks or computer games or training my animals, ANYTHING but football.

What a waste of a pig!

[steveegg]

Oh well, nobody's perfect :)

CNBC on and waiting for the opening bell. I've got Dow up 35, NASDAQ up 7 and S&P up 2 inside of 5 minutes.

[steveegg]

I was a bit pessimistic (that's the bear in me). Dow opened up 66, Nasdaq up 39 and S&P up 8 (hey, at least I was close on S&P). Enjoy the bubble.

[Little Bush]

Hey, was I the only person on the planet who knew the dot-com crash would come? What goes up always comes down. I was actually very surprised it lasted as long as it did.

[steveegg]

Anyone who remembered the old rules of stocks knew that the bubble would burst. What you and I forgot to factor in was the political factor (S(l)ick Willie needing a large, long-lasting bubble to survive).

Dow +224
NASDAQ +49
S&P +21
Curbs are in (can't have a wild one-day swing back up, can we?).

[steveegg]

You're off by a day, but if you're a day-trader, you had best have bought yesterday afternoon.