J.D. Steinhilber
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The scope of recent events in the financial markets has been nothing short of dumbfounding. Stock, bond and commodity markets have crashed. The MSCI World Equity Index, the broadest measure of the global stock market, has plunged 30% in the past three weeks, and 19% last week alone. U.S. investment-grade bonds have dropped 18% over the past month. Commodity indexes have fallen 20% in three weeks and 40% in three months.
The implosion in global capital markets has been truly extraordinary, and certainly not what I was expecting. I had expected a continued drawn out unwinding of the credit excesses that had accumulated over the past two decades, rather than a spectacular collapse.
Coming into this past week, I thought that markets were "sold out," and close to an important short-to-intermediate term bottom, but clearly we crossed a critical tipping point early in the week, and things spun utterly out of control. Despite a series of historic government measures to restore confidence and unfreeze credit markets (e.g. backstops for the commercial paper markets, and guarantees for money market funds), we witnessed a massive global flight to cash, driven principally by forced liquidations of leveraged financial institutions and hedge funds (i.e. margin calls), and exacerbated by panic selling by individuals and fund managers scrambling to raise cash to meet redemptions. The result was a financial markets massacre.
In last week's comment, I (perhaps cavalierly) dismissed comparisons to the Great Depression period, but I now think it is no exaggeration to say that the crisis of confidence in our financial markets and institutions is at or near levels last seen in the 1930s. Markets and financial institutions are in an unpredictable state of chaos and upheaval, so it is hard to have confidence in what might happen next or how quickly markets will heal.
We have fallen much further than I thought was possible in even the worst-case scenario, and all risk assets seem to have dramatically overshot to the downside. Amazingly, Friday's low of 840 on the S&P 500 was within 50 points, or 6%, of the lowest price recorded in the 2001-2002 bear market. In other words, the current bear market wiped out 94% of the gains achieved in the 2003-2007 bull market.
An array of fundamental, technical and sentiment indicators suggest that we are at or very close to a major stock market bottom.
- At the close on October 10, 2008, the S&P 500 "normalized" P/E ratio, based on a five year normalized average of earnings, was 12.3x, which ranks in the low 18th percentile of the past 50 years. This is historically very undervalued, especially in the context of low rates on riskless, interest-bearing alternatives (e.g. T-bills and CDs). Foreign stock markets are even cheaper. For example, the stock markets of Hong Kong, Singapore, France and Germany now have single-digit P/E ratios and 5%+ dividend yields. The Japanese stock market is trading at 1x book value. The entire emerging markets index, with all the growth potential it represents, trades at 1.25x book value. Global stock prices appear to have more than discounted a deep, protracted worldwide recession, such that the risk/reward from current prices seems very positively skewed.
- Stock markets are oversold to a degree not seen since the Great Depression. On Friday, 75% of all issues traded on the New York Stock Exchange hit a fresh 52-week low. The previous worst reading in the post World War II era was 58%. A number of other technical stock market indicators (e.g. put/call ratios, volatility readings, percentage of stocks above their 200-day moving averages, the distance the S&P 500 has moved below its 200 day moving average) have moved to their most extreme levels in the history of the data.
- At Friday's low, the S&P 500 Index was down by 45% from its October 2007 peak, which means that the current bear market now ranks with the biggest of the past century. No bear market since 1937 has lost over 50%. The last 9 market days have seen a 25% decline in the S&P 500. That's only happened twice in S&P data history, during the crash periods of 1987 and 1929. In both instances, the stock market was higher one week, one month, three months, and six months later. In fact, the average 6-month gains were 15% and 21% respectively.
- Based on a wide variety of measures, investor sentiment is as bearish as it gets, and history has repeatedly shown that market bottoms are by definition the point of maximum pessimism.
- Given that this is a global financial and economic crisis, and global economies and markets are inter-connected and inter-dependent to a degree never before seen in history, we expect to see global cooperation by governments and central banks in a massive effort to re-liquefy the banking system, re-flate asset values, and restore confidence. We have already seen numerous examples of this (e.g. the U.S. announcement last week to provide, through the Commercial Paper Funding Facility, direct financing to the U.S. economy and compensate for the breakdown in bank lending), but markets, in their recent state of panicked and forced liquidation, have been oblivious to such historic measures.
Fear is the strongest of motivators, but all of this evidence suggests that now is a terrible time for investors to panic, throw in the towel, and abandon a long-term investment plan. There are no guarantees that markets won't go lower still (as inconceivable as that seems) before a final bottom is reached, but if your personal balance sheet is in reasonable shape, and you do not have to sell due to margin calls or liquidity needs, you should resist the emotional urge to sell to stop the pain. If you are in a position of having to reduce exposure for liquidity reasons, or because of a re-evaluation of your risk tolerance, it is best to do so in stages after inevitable relief rallies rather than at the likely point of maximum fear and extreme panic selling.
While this is not the time to be selling stocks, unless one has to, it is also not the time to be taking aggressive additional risk with the aim of quickly recouping prior losses. The blow-up has been so spectacular, no one can be certain of what the immediate future holds. The architecture of our financial markets has broken down and will have to be rebuilt. Our economy is facing a painful adjustment period to reduce our overall debt loads and repair battered balance sheets. Investor confidence has been shattered.
All of this suggests that the average investor should sit tight and ride out this storm. Investors fortunate enough to be under-invested relative to their neutral risk posture should view this as an attractive longer-term entry point and take advantage of bargain prices in risk assets.
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This article has 26 comments:
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Owen
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138 Comments
Oct 12 04:50 PMEven more telling is the equity risk premium, which is the difference between the earnings yield (the inverse of P/E) and the risk-free interest rate, which is now clocking at around 800bp, the highest since the 1930s and twice as high as other market bottoms since World War II. Equities are now earning 8 percentage points above, or three times as much as the best yielding treasuries, versus the typical 1-3 percentage points.
Another telling indicator is the sweeping bearish sentiment, as we'll likely soon see here in the next few comments.
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TraderGreg
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28 Comments
Oct 12 05:11 PMIn the longer term, it is my opinion, that we are only half way through the bear market. This is what it feels to me - a rebound, half way through this adjustments.
We baby boomers, need to deflate assets before we retire, so the next generation can live their American dream....
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junkinthesack
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5 Comments
Oct 12 06:03 PM-
Distressed Volatility
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53 Comments
My Website
Oct 12 06:28 PM-
ddtuttle
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13 Comments
Oct 12 06:41 PM2. Oversold indicators only make sense when the market is in relative equilibrium. It presumes a population of buyers hungrily waiting for their entry point. No such thing right now.
3. Just about everything in this crisis is 'the worst since the great depression'. Well, we just put in the worst day EVER on the Dow. In other words, we now have one metric whereby this things is WORSE than the great depression. Your 50% down is still in play, which is more than 1000 pts below where we are now.
4. Investors are bearish because real estate prices are still in free fall, we still have to unwind trillions upon trillions of toxic deriviatives, the US banks have $8T of level II & III debt that is may be worth $0.10 on the dollar, the US government is printing money so fast the presses will catch fire, the entire global financial system has collapsed and we are HOPING the world governments can resuscitate it, and we are still in a steep economic decline. Yeah, everybody's way too bearish.
5, Expecting government to cooperate is naive. If this gets worse or lasts too long it will rapidly devolve into everybody for themselves.
Now having said all that, a fast large snap back rally has to happen in here somewhere. It would flush out all the shorts, sending it even higher. But that is only a trade, not an investment. The whole world in hanging by a thread, and the risk profile for equities depends on the immediate context, and that sucks right now. I would quantify it as a couple of percent upside against 10-20% downside.
In virtually all the episodes like this one, it has taken 10 years or more for equities to recover. So investors beware.
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Crudeman
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10 Comments
Oct 12 06:52 PM-
BxCapricorn
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155 Comments
Oct 12 06:58 PM-
Moses
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49 Comments
Oct 12 07:52 PM-
MarketLost
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7 Comments
Oct 12 07:58 PMHistorically, we will form a complex bottom, and retest the lows within a few months. Then it's a new bull leg from there.
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eternitus
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52 Comments
Oct 12 08:26 PMForget charts and historical comparisons (a sample set of 2-3 tells you nothing of consequence). There are too many variables that are different right now. If you drop the Dow's profits by 30% (I think this is unlikely, given that bank profits will actually rise as a result of the TARP and Fannie and Freddie stealth TARP), the Dow will still only be trading at a PE of 15 and yielding 3%+... this will be at a time when cash on the sidelines (there is an enormous amount of this) is counting its returns in basis points.
Buy wide-moat, established companies with low debt, high cash flow, solid yields and <60% payout ratios, and get paid to wait for the flood of sideline money to float your stock values higher.
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SugarDaddy
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33 Comments
Oct 12 09:10 PMThe info exchange is just too fast to deliver the wrong news most of the time.
The attitude of sit on the sidelines isn't going to work this time.
Cash is King and Gold/Silver are the queens..
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Jackson Cash
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293 Comments
Oct 12 09:29 PMSorry Charlie, this sentence sums up the entire article. This crisis has been a surprise to a LOT of self proclaimed experts. Therefore I don't think we are anywhere close to a bottom... Sentiment doesn't tell me that, submitting to "I don't know, and neither does anyone else" does.
The premises you ought to be exploring is "what have we or will we give up in order to stop the crisis?" I'd suggest that you start with transparency, failure of Congressional leadership through oversight, and the elimination of the Federal Reserve.
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Moral Hazards Amok
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37 Comments
Oct 12 09:54 PM3. imho, we have had far too few meltdowns of this severity to reasonably game where this current one will end and a new bull leg will begin, or how high the rally will go. I would think that we would need at least a couple hundred meltdowns to gather statically meaningful trends. Too many people from Cramer to Roubini compare this crisis to 1987 or 1929. Today’s crisis is neither because important dynamics are so different. Sorry to use the overused cliché, but we really are in uncharted waters. Throw away the book on those past episodes when it comes to predicting the current market. They don't apply, imho.
4. It would have been nice to know what specific measures the author was referring to. VIX, Put/Call ratio, magazine covers, newsletter authors, men’s beards? Not all of these indicators are yet at pessimistic extremes. Also, how do we quantify “maximum pessimism”? I would be willing to bet that at the bottom of every economic crisis the population believed that things indeed could get much worse, and guess what, they were right. So how do we know when we’re really at a bottom?
That being said, my technical indicators suggest that we may indeed at a short-term bottom and ready for a good bounce, so late Friday I stuck my toe in the water and bought calls in ABK and IDEV. But I used specific (albeit rule of thumb) quantifiable indicators. We shall see.
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cpeterka
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16 Comments
My Website
Oct 12 10:05 PMUntil the banks start to Trust each other, Until merchants get short term capital, this will continue to fall.
Grain is piling up in the ports ( Canada, US ) because the buyers can not GUARANTEE that the money they promise for the grain they want to buy will arrive from their bank.
The traffic in the ports is down by 20%. Joe Smallshop, and Frank Big Company NEED Short Term Capital, and until the banks TRUST them, things will continue to spiral downwards.
Sorry, I'm holding my cast for better bargains.
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tenandeight
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3 Comments
Oct 12 11:41 PM-
Alexander77
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37 Comments
Oct 13 12:38 AM-
Nikola
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91 Comments
Oct 13 01:35 AMWe will surely have a technical rebound. Just in time for the "analysts" to cash out.
Bottom or not, we're not gonna see Dow back in the 5 digits for at least a year and probably two or three. And that's an optimistic scenario. This time to take the Dow back up folks are gonna have to work for it. You won't be able to scam'em into it.
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Eagle-Chief
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72 Comments
Oct 13 02:23 AMVladamir Putin was on CNNMoney.com saying that the world has probably lost confidence in Wall Street FOREVER. Forever is a long time. Why have they lost confidence? Because Wall Street and its "investment experts" have been selling fraudulent securities to the American public and to foreign investors for years. And now the game is OVER. The fruad has been exposed.
Americans and foreign investors have entrusted their money (and their retirements) to these fruadulent firms for years. Sadly, because of Wall Street's deception and greed, America will FOREVER lose its position as the center of world finance and investment. Why should investors, foreign or domestic, place their money into the trust of Wall Street money managers who have bankrupted their companies, walked away with million dollar salaries and bonuses and are now bankrutping America and the rest of the world?
Sit tight and ride out this storm? I don't think so. Wall Street and investing in stocks in American has been unveiled to reveal what it is - a con game from the very beginning designed to enrich the corporations and the "investment experts" on Wall Street. Sadly, the hard-working investors saving for their retirement are the ones who are having their LIFE SAVINGS EVAPORATE.
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jerrypan
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2 Comments
Oct 13 05:43 AM-
kowalski
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50 Comments
Oct 13 08:29 AMyes,
Wall Street is a con game, but people have short term memories, and as long as there is capitalism, a need (even a desire) to make money..
I have seen this scenario unfolding many times before, and I doubt it will be different this time, because - quite frankly - there is no alternative... not as long as human nature is what it is: stupid and greedy!
Besides, Putin is the wrong man to make comments on who has lost what and for how long... Russia is the worst and most corrupt country of all!
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xl4hf
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3 Comments
My Website
Oct 13 08:32 AM-
oldman
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69 Comments
Oct 13 10:14 AM-
secmaven
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305 Comments
Oct 13 10:45 AM-
Crude.Expert
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8 Comments
My Website
Oct 14 01:18 PM-
eternitus
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52 Comments
Oct 14 03:06 PMAnyway, if you are a long-term investor, who cares if this is the ultimate bottom or not? You have to be insane not to put at least some money to work at these levels (unless you think people are not going to just cut back but simply stop buying hamburgers, shoes, toothpaste, etc.) You have 30% downside to TTM earnings to work with for the market not to look cheap. We might get there in terms of earnings, but I haven't seen risk/reward look this good in a very long time... especially in light of stock's competition from treasuries, where the 10-yr out-yields the Dow by an incredible (sarcasm) 50 bps.
I'm with Burton Malkiel... nobody has ever made money consistently selling America short.
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dick12369
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1 Comment
Oct 31 04:44 PM