Ghoulies and Ghosties

John Mauldin | Thoughts from the Frontline
September 28, 2001

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

--Old Scottish Prayer

The cheerleaders are proclaiming we have visited The Bottom. Dark as a Texas canyon at midnight, it was scary; full of bears and ferocious short-selling beasts. They are glad we have finally left it behind to enter the green pastures where bulls placidly graze. Now, after the shock of the last few weeks which triggered the sell-off they have been waiting for, we can resume the Bull Market, although they admit there might be a few bumps on the way. As evidence, they point to today's NAPM Index for September, which is up, although still in negative territory.

Stock markets, we are told repeatedly, start to recover about 6 months before the economy does, and since the recovery will start in the first quarter of next year, it is time for the market to rally. (If I see that @*%$# Schwab commercial one more time telling investors to "First, take a deep breath.......")

Yardeni, while lowering earnings estimates tells us: "Based on my recent conversations with portfolio managers, I believe there is also a growing consensus that the economic and profits scenarios will be V-shaped. Everyone agrees that the recession will worsen through the end of the year. But now many see a stronger recovery next year because monetary and fiscal policies will be very stimulative." (Note who is getting confident: Portfolio managers. Not consumers. )

I am perfectly willing to be led into greener pastures. As one of our Three Amigos, the NAPM index going up is a good thing. But I hear things bumping in my closet. Maybe they are simply ephemeral ghosts of bear markets past, not yet willing to leave this world. As I tell my children, ghosts can't hurt you. However, the bumping is rather persistent, so I think we should bravely crack the door and peak into my worry closet and see if anything more substantial than a few ghoulies and ghosties reside therein.

The Ghost of Expectations

A continual theme in this letter is that if this is The Bottom, it will be the highest bottom in terms of value in history. In reality, it will be a higher bottom than any previous top, except for a few months at the height of the last bubble markets.

The Nasdaq 100 is trading at 102 times 2001 earnings forecast by Thomson Financial/First Call, and 52 times expected 2002 earnings (adjusted for actual weighting) . As I look into the darkness of my closet, it is the ghost of the word "expected" is that is going bump in my closet.

Weighted aggregate Nasdaq 100 earnings are expected to be $25 billion for 2002, nearly double the $13 billion forecast for 2001. Somehow, analysts expect the NASDAQ 100 earnings to grow by almost 100% in the next year. That is IF they actually earn $13 billion, which is a very BIG IF.

Peter Eavis, no perpetual bear, writes: "Next, let's be insanely generous and assume that the Nasdaq 100 deserves to trade at 40 times those weighted 2002 earnings. That would give the 100 a market cap of $1 trillion, and an index value of 915, 23% below Tuesday's close. Apply the same drop to the Nasdaq Composite index and you get 1155."

Ben Stein reports that the current 2001 earnings for the S&P 500 are now down to 36. That means, as I glance at the trading screen, that current P/E ratios for the S&P 500 are in the neighborhood of 30! That is higher than I ever saw reported when the index was at 1500, which is 50% high than today's value.

Yet analysts are sticking to their earnings forecast of $55 for 2002. "Now, $55 per share is a reasonable estimate given the awesome combination of monetary and fiscal stimulus that will be provided." That was Yardeni, one of my favorite analysts. I hope he is right, but I am having trouble buying even $45, let alone $55.

For reasons outlined below and in recent letters, a first quarter recovery is unlikely, in my opinion. We will be pushing it to get back to tepid growth in the 2nd quarter. With all the stimulus in the economy, solid growth is possible, even probable, in the second half. It seems we will have the second half recovery analysts predicted last year after all. Just one year later.

However, even with a solid last half of the year, it is hard to fathom how earnings of the S&P 500 will grow almost 50% - to $55 - on the strength of the last two quarters.

I am reading a long and hard to understand report by three economists. They need a style editor, God love 'em. I am slogging through it, painfully, because it is an important report, and I want to summarize it for you in a future issue. It is full of calculus and caveats, but one of the main points is this:

Analysts are optimists.

Duh, you tell me. But this paper points out how unbelievably optimistic they are. I will give you one example, teasing you with the implications, and will take up this paper at a later date.

If you "take as an example a stock with a current price to earnings multiple of 100, which declines to 20 in ten years' time with an expected return of just 10% per year to the investor. Earnings must grow at 29.2% per year for TEN YEARS to justify the current multiple. This is a tall order by historical standards." In particular, the required growth rate is in the top 5% of all companies. If earnings grew at 14.7%, which would be in the top 25% of companies, it would take 38 years for the P/E ratio to fall to 20. (This is an edited quote from a National Bureau of Economic Research report by Chan, Karceski and Lakonishok. Brilliant paper, guys. Awesome. Get an editor. Please.)

Point: The NASDAQ 100 is not some investment Lake Wobegon, where all the children are above average. History tells us 5% of stocks may be able to grow by 29% per year for the next 10 years, but not all 100. And that history was accomplished in a raging 18 year bull market.

In fact, I will bet anyone reading this $1,000 to their favorite charity vs. $1,000 to mine, that five NASDAQ 100 companies do NOT grow by 29% for the next 10 years. The far safer bet is that 5 of them will not exist in 10 years.

The NASDAQ, as I look at the screen, is at 1489. How much lower, I am asked every day as I talk to potential clients who have been killed in the market, can they go? The answer is a lot.

Stock prices are not a function of some static model, but of something far more ethereal: investor expectations.

Indeed, I am accused of continually talking about P/E ratios as if they were almost sacred. They are not. They are just one more way to look at value. Looking at value historically, the NASDAQ is still over-priced by AT LEAST 25%, and maybe more.

But if investors choose to ignore my sane and reasonable approach to stock valuations, then the market will go up, somewhat like the fabled bumblebee after listening to the aeronautical engineer's lecture. In theory, investors could ignore historically reasonable valuations forever.

And if or when the market drops again, it will not be because investors one day wake up and say, "Mauldin was right. Stocks are over-valued, therefore I will sell." It will be because they are concerned about the future, and no longer see stocks as a way to insure their future.

They will no longer be asking, "Who moved my cheese?" They will be saying,

"Forget the Cheese, I Want Out of the Trap."

Take a clue from last week. Institutions and money managers were selling. They were selling at lower prices than today. The small investor, we are told, is standing pat. But for how long?

Investors are going to get tired of playing the relative value game of Modern Portfolio Theory. They are going to get tired of listening to Charles Schwab tell them to expect a few bumps.

Charles, 40%-80% drops are not bumps. If it is in your retirement portfolio, it is a disaster. Telling people to be calm when they are down 50% is not what they need to hear. What they needed to hear was how to protect themselves from 50% to begin with. They now need 100% growth to get back to where they were. But in what market? And over how many years? In what industry are we going to see 15% compound earnings over the next five years which will double our stock values? That is what investors need to hear. Not platitudes.

OK, off my soapbox.

The Ghost of Earnings Growth

Earnings growth is extremely hard to predict, in the best of times. If earnings, or the expectation of earnings, really drives the stock market, then at what point do investors realize that earnings are not going to grow at 15% per year, let lone at 30%?

Earnings cannot grow everywhere at 15% if the economy is only growing at 2-3%. Referring to the study one more time, it conclusively demonstrates that it can happen in a few companies for a period of time, but that it is rarer than analysts predict. Analysts live in a Lake Wobegon world, where all the companies are above average, especially the ones where their firms get big investment banking fees.

Hotels are running in the red. CNBC shows pictures of O'Hare airport with no one in lines. Nordstrom Inc. is slashing prices on clothes, shoes and accessories by as much as 60 percent in the next week, the first early autumn sale since the company started selling apparel almost 40 years ago. Other chains will follow suit. Rule: You can't make your profit projections if you slash prices by 60% in October. Like the Aggie selling apples for a nickel which cost a dime, you can't make it up on volume.

Construction projects are being shut down. New spending is slowing down, as companies do whatever they can to preserve cash and make a profit.

Remember I wrote a few months ago that businesses were holding off laying off employees in the hopes for a recovery? That hope is rapidly fading. Layoffs are their highest since 1993, and will be going higher.

Consumer confidence once again dropped to its lowest level in years, which is not a surprise. But as lay-offs come, and no quick fix for the War on Terrorism emerges, confidence is likely to drop some more.

How do bear markets end? When all the selling has been exhausted. We are far from that point. Earnings are not going to turn up on a year to year basis for at least two more quarters, and probably three. Will investors wait? Not if one more trend starts to take over.

The Ghost of Housing Prices

GregWeldon reports that housing prices are falling:

"We note the stats released this week pertaining to the median values of new homes sold during August ---
--- Deflated for third month in a row, down a MASSIVE 2.7% for the month
--- Down 4.4% in just the last three months ... or a 17.6% annualized pace.
--- From $175,300 in May ... to $167,600 in August
--- Significant acceleration in magnitude of monthly decline ...
... June ... down 0.6% month
... July ... down 1.1% month
... August ... down 2.7% month
OUCH. Might we then expect even LOWER consumer confidence ??"

That got me to thinking about what drives housing prices. Having lived in Texas, I have seen huge fluctuations in the price of homes sin the last 20 years. There have been times when you could buy homes for a fraction of their actual replacement value. Actual replacement value means nothing at times.

Of course, we all believe that supply and demand is a cornerstone of market prices, but just as stocks have elements of value and emotion, there is another element in the housing price equation.

One element I think that is over-looked is personal cash flow. Americans, including me, are in love with our homes. They are our castles and our savings banks. We tend to buy as much home as we can afford in the thought that the price will go up, and as we pay down the mortgage, we are actually saving for the future. So we estimate our cash flow and buy what we can.

But what if cash flow goes down? Then we sell, and buy a less expensive home. In a growing economy, there are more people whose cash flow is growing than those whose cash flow is dropping, so there is no downward pressure on house prices. This is really accentuated if mortgage rates drops as buyers can afford "more" home, and optimistically buy what they can pay for.

I was talking to a major home builder in a mid-western state this week. He notes that home sales in his mid-priced range homes are still doing ok, although he intends to reduce inventory. But high-end homes in his area have dropped a lot.

The reason that average home prices are dropping is that the prices of the most expensive homes are falling and bringing down the averages. That is because the cash flow of higher net worth buyers is falling. Their confidence or their ability to pay, as they watch their stocks take hit after hit, is waning.

In Texas, as unemployment went up in the 80's, home prices dropped, sometimes dramatically.

Point: as unemployment rises, housing prices will fall. Last week, analysts told us stocks dropped because while many may have not been selling, even fewer were buying. The same could happen to housing.

If the balance between buyers and sellers gets out of whack, you could see a drop in home values. If that happens, consumer confidence will drop far more than we have seen from the stock market. If home prices drop, then new home builders will suffer, as their margins erode.

The Fed must be worried about this. They have dropped rates and will drop some more (as predicted by your humble analyst for months). But long term rates have been stubbornly resistant.

Home lenders are becoming more conservative as well. Whereas last year they would lend to a warm body, now they want to see more qualifications in order to get the best rates.

Unemployment and tighter lending standards do not make for a robust housing market going forward.

But will things get truly bleak? Not if the Fed can help it. Right now, they are still behind the curve. But they will keep dropping rates until the economy responds and long term rates drop as well. If the Fed can pull down long term rates, then the housing market will remain stable, as cash flow will be the ultimate determining factor in housing prices.

Congress will act as well, providing more stimulus. I think it will be enough to keep the economy from truly sinking into a deep recession, but it will not take effect right away. We are still going to go through 2-3 quarters of recession, at least. This is going to be tough on consumer confidence. That means lower profits. Lower profits means tough times on Wall Street as investors adjust their expectations, and earnings estimates for 2002 begin to drop like they have in 2001.

Could we see a bear market rally? You bet. But with stocks valued so high, and with earnings dropping or growling slowly, History is on the side of a lower stock market.

I recently had a chat with Lynn Carpenter, the editor of Fleet Street newsletter, one of my favorites. She is a major proponent of value stocks. Her advice: if you are good at valuing businesses, there are some companies which are beginning to be real value stocks. She also thinks that in the future, there will be even more opportunities.

My conclusion: Now is NOT the time to jump back in the market, except on a very select value basis. We are at all time highs in terms of valuation. We are going to get even better opportunities, as I think value will become the watchword of investors within a few quarters. This means stocks with P/E ratios of 100 which cannot convincingly demonstrate 30% plus annual earnings growth are in for a free fall, even if they are already down 80%.

Bottom line: These ghosts are real, and those bumping sounds will scare stock market investors.

Repeat: That does not mean I think we will see GDP drop 3% next quarter, or that the end is near. All the stimulus to the economy will have an effect. There is nothing to make me think this is more than just an average recession.

But average recessions wreak real havoc with the stock market. Average recessions mean a return to the mean in terms of value. And that means we could still have a long way to go on the downside. There could easily be another 20% downturn from here. Of course, investors can always ignore History. They did in 1999 as they ignored nosebleed valuations in tech and internet stocks. They did in 2000 as they ignored the warning of the yield curve. (I did make those observations at the time.) Betting against my man History has not been a smart play. You can get away with it for awhile, but he gets you in the end.

Bond update:

I wrote last week that I was still bullish on bonds, despite being down 7% in one week. This week, we have made about 4% of that back. For those who are worried about the Japanese selling our bonds, and my correspondence indicates there are a few of you, I would point out that the Japanese Fed is doing everything they can to weaken the Yen against the dollar. They are very public about it. If you are a Japanese investor, why would you want to sell what will be the stronger currency? Of course, the Japanese central bank is so inept, they might not even be able to destroy their own currency value.

Phoenix and birthdays

Next week will be a short one for me, as I turn 52 next Thursday and my wife is taking me to Phoenix for a long weekend. I will be glad to meet with clients and potential clients on the afternoon/evening of Friday, October 5. Call my office at 800-829-7273 for details. I intend to golf Friday morning if anyone is interested. You will not see great golf unless you bring a good game, as my handicap is 29. I simply enjoy the game and camaraderie, so feel free to join me. I like to meet new friends.

I have been invited to do a keynote luncheon address at the GAIM conference in Boca Raton, Florida next January. This is one of the premier alternative investment conferences in the US, and focuses on hedge funds and other private offerings. I will be speaking on the "Fallacy of Modern Portfolio Theory." My speech will show up as an e-letter in a month or so, if I make my deadline. I am negotiating to get special rates for my readers and will let you know more details in a month or so.

I will be traveling a lot over the next four months, so I am doing my part to help the airline industry. I would enjoy seeing some of you in New York on November 5-6 or December 9-12 as I will be speaking at hedge fund conferences at those times as well.

I know this letter was not what many of you wanted to hear, but I try to be as candid as possible, just as I would be if you were sitting in my office. Things will get better. I will someday be a bull. I promise. Just not yet.

Your enjoying his life at 52 analyst,

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