Beware of Head-Fake Rallies
February 24, 2009
In addition to consumer deleveraging, government debt is skyrocketing with every bailout, thus taxes and interest rates are likely to be significantly higher once the economy normalizes.
The Earnings recovery will likely take longer than many expect, therefore, there is a very high possibility that the "average case" earnings growth going forward will be below the historical average of 6%.
Are we about to embark on a secular bull market?
The market is a discounting mechanism -- stocks will rise in the anticipation of a future earnings rebound, before the rebound. Similar to the stock market forecasting ten out of the last three recessions, it will discount a few recoveries before the real one takes hold.
What does this mean? We'll likely have a few "fake" head starts and disappointments before the actual earnings recovery takes place.
As I argued in my book Active Value Investing: Making Money in Range-Bound Markets, we are very likely in the midst of a secular range-bound (trendless, volatile but going nowhere) market that started in early 2000. Historically, range-bound markets started at the end of the secular bull market when P/Es were above average. They ended when P/Es stopped declining (mean reverting), after a visit to below average territory (around 10-11 or less). The current range-bound market started at much above average valuation and will likely rhyme with the past finish at below average valuation as well.
Based on the Pain of Mean Reversion chart we are trading somewhere between 30 and 10 times earnings. However, neither number is very meaningful. Let me explain:
- 2008 estimates of $28, the "E" in P/E of 30, are distorted by massive charge offs.
- The "average case," the "E" ($80) that went into P/E of 10, lies in a far away land that ... well, let me put it this way, you and I will get to grow sick of presidential campaign advertisements at least once or maybe even twice before that "E" is in sight.
- Even based on 2010 "E" estimates ($40) stocks in the S&P 500 are trading at 21 times earnings.
Despite the decline, the market is still not cheap. Sorry, we are not likely to embark onto the new secular bull market anytime soon. History and data suggest that the choppy markets that we have seen since 2000 will likely continue. Owning a broad market index will not pave a road to prosperity. It comes down to not just owning stocks but owning the right stocks.
P.S. As a side note I believe significant earnings write-offs will continue well into next year as financial stocks will pass their write-off torch to companies in energy, materials and industrial sectors -- stuff stocks -- that will be writing off the investments they've made over the last five years.
By the time, I finished putting these thoughts together, which on and off took about two weeks, 2008, 2009 and 2010 estimates were taken down by about 20-25%.
Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates. He teaches a graduate investment class at the University of Colorado at Denver. He is also the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007).
P.S.S. The painting is by my father – Naum Katsenelson
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