Closer to bear market - closer to the next rally

Since our commentary of last week, US and world stocks markets slid another 5% on average, taking most to within a percent or two of the official definition of a bear market (a decline of 20% from the previous peak.)  Indeed, France (CAC), Japan (Nikkei), Hong Kong (Hang Seng) and India (Bombay) are already there.

Market	Current	vs 52 Week High
DOW JONES INDUS. AVG	12,099.30	-14.8%
S&P 500	1,325.19	-15.9%
NASDAQ COMPOSITE	2,340.02	-18.2%
MSCI EAFE	2,050.86	-14.5%
DAX	6,790.19	-16.7%
CAC 40	4,744.45	-23.1%
FTSE 100	5,578.20	-17.4%
NIKKEI 225	13,325.94	-27.2%
HANG SENG	23,818.86	-25.5%
SHENZHEN SE COMPOSITE	1,448.18	-8.6%
BOMBAY STOCK EX 500	7,195.23	-20.0%

As of close of trading in Europe on Monday (US trading closed in honor of Martin Luther King Day), the S&P 500 and NASDAQ futures indicated that US markets would open another 4-4.5% lower, which would put the US markets in bear territory as well. 

Rational analysis of the situation has gone completely by the wayside; investors are blindly selling without regard to valuations.  Last week saw horrific earnings reports out of Citigroup and Merrill Lynch, but also terrific reports out of Intel and IBM.  No matter - all stocks were marked down.

As we wrote in our last commentary, "We're gritting our teeth, not selling stocks and looking to deploy cash at the first opportunity."  According to several models that we follow, stocks are at the cheapest levels in the last 12 years, possibly the last 18 years.

This chart shows the range of P/E (price earnings) ratios of the S&P 500 since 1990.  The solid black line tracks the S&P 500 price on the left axis, the PE value is on the right axis.  Generally, P/E's of 20 or less are bullish for stocks.  Right now, we have a trailing P/E (last 12 months, solid green line) of 17.69, which is the lowest since 1996, and a projected P/E of 14.69 (forward 12 months, dotted red line,) which is the lowest since 1990 (the junk bond debacle/emerging market debacle/last real estate crisis). 

The 2002 peak in P/E ratio corresponded with the collapse of the dot com stocks (which never had real earnings, and the implementation of the Sarbanes-Oxley rules, which compelled companies to clean up their earnings reports.)  Since 2003, US companies have expanded net income and earnings at a dramatic rate, but the stock market has not kept up, hence the dramatic compression of P/E ratios.  The stock market barely beat the March 2000 high in October 2007, but has since declined 16%.  Low P/E stocks are safe stocks; a low P/E stock market is a low risk stock market.

Generally speaking P/E ratios expand when interest rates are falling.  If for example, interest rates fall from 5% to 4%, and GE's P/E ratio expands from 20 to 22, the stock price will rise from $60 to $66, assuming the earnings stay flat.  If GE's earnings rise 10% as well, then the stock goes to $72.60. 

To consider P/E ratios in the context of interest rates, look at this chart:

What we see is that from 1968-1998 is that fair value (earnings growth discounted by the prevailing ten year treasury yield) and the actual value of the stock market hung pretty closely together.  The relationship broke down between 1998 and 2003, with the actual value by December 1999 108% (over double) of the fair value.  As the market collapsed over the next two years, the fair value inverted and by February 2003 the actual value of the stock market was 32% below fair value.  Although stocks have risen since then, the gap never closed and the stock market remains 20-30% below fair value, depending on whether you are conservative or aggressive with assumptions about treasury yields and earnings growth.

Earnings for 2007 are projected to come in at 8.0% which isn't bad considering that the losses in financials such as Citigroup and Merrill Lynch give that sector grown in earnings of negative 8.9%.  In 2008, the earnings of financials are projected to snap back with gains of 9.1%, and 11.7% for the entire S&P 500.

The Fed was hesitant to cut rates from August through December, as the breadth and depth of the CDO sub-prime crisis wasn't that apparent until this week's earnings reports from Citigroup and Merrill Lynch.  Given the rate that inflationary pressure is diminishing(oil down over 11% since the January 3^rd peak, lower housing prices expected in 2008), the Fed can continue to cut rates aggressively (probably another 50 bps at the end of January, probably an additional 75 bps by September.)  Stocks ALWAYS rally in that kind of environment.

Strategy

The world situation for stocks looks incredibly grim right now.  But so did the situation following the 9/11 attacks, the 2000-2002 tech wreck, the 1998 emerging markets currency crisis, the 1991-2 junk bond/real estate debacle, the 1987 "Black Monday" portfolio insurance wipe-out, the OPEC oil shocks of the 1970's, the traumas of the 1960's (Vietnam War, assassinations of John, Robert Kennedy, Martin Luther King.)  In hindsight, each situation proved to be a buying opportunity and the current situation will prove to be no different, as long as we maintain our strategy of buying real companies with real products, real earnings and the real possibility of growing those earnings at a sustainable rate. 

We sold off our remaining positions in bond insurance companies last week, but otherwise are staying fully invested in anticipation of a rally which probably won't occur this month, perhaps not even this quarter, but assuredly by the end of this year.