Written January 2009
As most people know by now, the domestic stock market fell approximately 38% in 2008. Shockingly, this performance figure was one of the better returns experienced in major equities indices throughout the globe.
After just completing the worst year for equities in 77 years, the most common question is “Now What?”. Overall, the OPCM Investment Team has never experienced as much conflicting data, diverging opinions, or as wide a spectrum of potential outcomes for an upcoming year in our careers.
Since Fundamentals, Valuation, and Sentiment are the main stock market variables, below we list the positive and negative scenarios for each factor, while describing where we see a possible bias.
FUNDAMENTALS:
Positive: Unlike most recessions, this recession is missing some of the major ingredients such as high inventories, high debt, and over-hiring. First, in past recessions, the government’s inventory/sales ratio has peaked around 45-50 days of inventories prior to the recession. Today, after a full year of a recession, that number is 40. Second, the average debt-to-capital ratio of the S&P500 is near a historic low at about 30%.
Negative: Arguably over 50% of the stock market sectors are in the middle or late stage of “busting”. Financials have popped and are attempting to recover. Energy busted very quickly and is due for a rally; however, there is a lot of backing and filling needed to create a bottom. The more cyclical industrials are arguably near the beginning of a bust, with certain segments of industrials needing years to recover. Finally, basic materials was a pure boom-bust situation.
VALUATION:
Positive: Over the long-term, two of the better valuation indicators have been 1) price-to-10 year average Earnings Per Share, and 2) interest rate adjusted Price/Earnings. Using these two valuations, the S&P 500 at 903 and 10 year EPS of $62 equates to a P/E of 14.5x, which is below the long-term average of 16.5x. At the November low, the P/E of 11.9x was one of the five lowest in history. On an interest-rate adjusted basis at the November low, the S&P 500 was trading at a P/E of 8.5x, down from 32.5x in 2000. At 8.5x, the only time we have registered a lower interest-rate adjusted P/E was at the 1974 low.
Negative: Over the short-term, 2009 earnings for the S&P 500 could pierce below $50. In an irrational market that does not factor in interest rates or inflation, there is no reason a 12 P/E could not be attached to $50, for an ultimate S&P 500 low of 600.
Bias: While the last 15 months has proven that anything is possible, rationally and historically, there should be little risk below the November low.
SENTIMENT:
Positive: November saw a number of capitulation-type events caused by everything from individual mutual fund investors hoisting the white flag and selling to hedge fund redemptions to dozens of major hedge funds closing with 60%, 70%, and 80% losses.
Negative: Presently, the professional managers are not as bearish as usually seen at a major bottom. Although at the November low only 23% of professional investors were bullish, that number has crept up to 39% with the percentage of bears falling from 53% to 39% in six short weeks.
Bias: Curiously, history has shown one of the best indicators of an eventual stock market bottom is individuals making record mutual fund redemptions. Mid-October through November were certainly records for mutual fund redemptions. Overall this is a long-term positive.
OVERALL:
Generally, most of the negatives are short-term while nearly all of the positives are long-term. The cumulative result is: Expect volatility to fall but to continue above historic norms. Depending on the magnitude of negative earnings revisions, the market will attempt to bottom in 2009. Finally, when the stock market does finally bottom, everything from corporate debt to inventories to operating expenses will be as gutted as we have seen since 1982. The result will be an extended bull market.
