If you are an arbitrage trader (trading without risk) you always want to “buy cheap and sell dear” in order to generate a profit. Equity investing is not risk free but many investors agree on two things: 1) stocks are cheap; and 2) they might get cheaper since “buyers” are on strike.
Yesterday we saw another major “yo-yo” session between buyers and sellers but stocks did end up advancing as buyers “conjured” up sufficient optimism to drive overall investor sentiment and stock prices higher. It was a major struggle and in the short-term it will continue to be struggle (likely into early 2009).
Stock markets initially declined after the National Association of Home Builders/Wells Fargo housing market index in the United States dropped 5 points to 9 in November. This the weakest level since the index started in January 1985. However, we did have some positive comments from Home Depot and Hewlett-Packard (HP) suggesting that it is possible to exceed expectations and navigate a difficult recession. HP said it expects 4th quarter and 2009 results to beat “Wall Street” projections. This was enough to push the stock markets higher but the rally did not have a lot of depth or breadth as not all companies participated in the rally.
Investors were also focusing on congressional testimony by Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson (okay they were having their job interview for the new administration – I think they won’t be around in 2009), who defended their $700 billion $U.S. bailout before the House financial services committee. The Trouble Asset Relief Plan (TARP) is not being deployed as originally stated. It has ‘thawed’ credit markets at this time but it is not helping equity markets stabilize since it is still very difficult to distinguish between the good banks that should remain and the bad banks that should be “put of their misery.”
The big 3 car makers were also on Capital Hill pleading for a “bailout” of their own. I find it interesting that Paulson insisted it would not be appropriate to let automakers have some of that money. However, I agree that “building a bridge to nowhere” is not a sustainable solution (but it wouldn’t be the first time that scenario has come to fruition). You will see an ‘overhang’ on stock prices until there is some further ‘guidance’ from Capital Hill on these issues.
The majority of companies have now reported their earnings for the third quarter. Actual reported earnings for the companies included in the S&P 500 are 36.3% below analysts estimated earnings (these people are not very accurate). In turn, analysts have dropped their earnings estimates by a very large margin and stock prices have dropped. Currently the prices to earning (P/E) multiple has dropped to 11.3 or an earnings yield of 8.8% (1/11.3) which means that companies who simply continue to generate the same level of earnings without any growth should see their stock price appreciate by at least 8.8%. In theory, companies should grow earnings over time with inflation and Gross Domestic Product growth. A P/E multiple of 11.3 for the S&P 500 has not been seen since early 1985.
There have only been two periods in the post World War II “era” when P/E multiples have been lower. In the period 1946 to 1954 things were cheaper and during the period of 1974 to 1984. If you look at the performance of the S&P 500 for the subsequent 5, 10 or 15 years you can clearly see that investments made during these “low multiple” periods generated above average rates of return. Only time will tell if this time will be the same or different but you are buying “cheap” with the objective of selling “dear” at some point in the future. You need a little “faith”.
I would expect consumer prices to drop (a lot) in the near term – car prices, gas prices, consumer prices for food etc…. (you will see record levels of deflation). Interest rates will drop further and eventually, people will start “consume” stuff at lower prices with cheaper “capital”.
I always feel that I run out of time and space but we need to see a substantial improvement in investor “sentiment”. In turn, for that to materialize, the bad news from around the world has to eventually stop. Until then investors will hold back on “fear” that we will once again test or breach the October lows. Fear can feed on its self and “we can talk ourselves over the ledge” and make things worse without justification.
We will see if Harper says anything interesting on his throne speech today.
Wilfred Vos Bcs, CFP, FMA, FCSI, CIM, CFA, MBA, DMS, CBV
SVP & Partner
