25 Jan 2008 It’s Not That Bad
There comes a point in market downturns when investors throw in the towel and begin dumping stocks at any price, just to get out and end the pain. These events typically come after longer and deeper routs, but Tuesday’s rout felt a lot like capitulation. It had many of the characteristics of a turning point. One thing is certain in equity investing and that is nothing is certain. Historical studies of market corrections are helpful to understand their general framework, but there is no magical formula to trigger getting out or in.
As of Tuesday the S&P 500 was down over 16% from its 10/31 high. The average peak to trough in recession-related slides since 1950 is 25.6% according to Citigroup strategist Tobias Levkovich. But, before rushing to conclude that we have another 10% to go, consider a couple of key facts. Equity valuations are considerably lower this time than at the outset of prior recessions. The S&P 500 is currently valued at 15.4 times estimated profit, the lowest since January 1991 (just before the last recession) when compared with actual earnings, according to Bloomberg data. And second, there is only a 50% chance of recession this time. Many key economists are saying we can miss it altogether with only a slowdown. But even if recession is already upon us, the market’s drop to date may be sufficient to discount recession – a brief one.
Tilmann Galler, a money manager for JP Morgan points out that “companies which are not directly consumer related or part of the financial industry are reporting good earnings. Looking at fundamentals the situation is not that bad.” David Bianco at UBS AG and Thomas Lee at JPMorgan Chase & Co. say the S&P 500 is already pricing in an economic contraction. And once markets have discounted for recessions prices begin to move up. In the past five recessions, shares reached their lows before the largest declines in earnings growth. Stock prices rose 22% on average over the following six months, according to Bianco. Lee said that “markets have overshot, and that we are really approaching a very, very tradable bottom here.” Numerous analysts are calling for an 18-20% rise in the market from its eventual bottom, if we are not already there.
The selloff delivered numerous buying opportunities for those who believed the bottom was near. On Tuesday Wachovia Bank traded at 76% of its 2007 estimated book value. The dividend yield was up to 10%. Citi, Bank of America, and JP Morgan represented similar valuations. The nation’s largest municipal bond insure, MBIA’s stock which had traded in the high 60’s in October reached a low of 6.75 on Tuesday. The stock’s dividend of 1.32 (which could be cut, but not necessarily) presented a yield of 20% and an 87% discount to book value. A compelling article by Jonathan Laing in Barron’s prompted my interest in MBIA. In it he pointed out that conservative estimates of the worst case break up value for the insurer were in the $30 to $40 per share range. We bought it and Wachovia on Tuesday.
The Congress and the Administration are rushing a stimulus bill through with the goal of having a bill on the President’s desk in three weeks. It took until March of 2002 to enact the stimulus plan prompted by the September 11, 2001 terrorists’ attacks. But true to their goal the House and the Administration accomplished the unthinkable yesterday by announcing a compromise and passing a bill to the Senate. But it could very well fall apart in the Senate as they bring their ideas to bear on the problem.
Under the House plan individuals would receive rebates of up to $600 and couples may get $1,200, plus $300 per child. Rebates would be phased out for individuals earning more than $75,000 and couples earning more than $150,000. Individuals must earn at least $3,000 to get a $300 rebate. The plan also addresses housing foreclosures by including a provision allowing Fannie Mae and Freddie Mac to temporarily buy mortgages of up to $729,750, exceeding a $417,000 federal limit. Business would be able to write off twice the amount of equipment purchases in 2008.
The Federal Reserve joined the save-the-economy party on Tuesday with a .75% cut on Tuesday and may cut rates further when they meet next week. It represented the first emergency (non-meeting) cut since 2001 and the largest one in 23 years. Stocks typically do well when the Fed eases because as interest rates fall bonds become less appealing and the earnings and dividends of stocks, comparatively become more attractive.
We are hopeful that the worst of the market declines is behind us, but we are sure that volatility will remain in the months ahead. As data on corporate earnings and the strength of the economy comes in there will be swings. There also remains a great deal of recovery and discovery in the financial and housing industries. But we believe that volatility brings opportunities. We are doing our homework to be ready for those opportunities.
Have a good weekend