What’s that Churning Sound

John Mauldin | Thoughts from the Frontline
May 7, 2001

Today we area going to address two topics. The second will be what the numbers tell us about where the economy is headed.

But first, I want to go back to a letter I wrote a few weeks ago. In it, I suggested you get out of the stock market, as the data I am looking at suggests the market is due for a serious drop. That did generate a few negative responses, though not as many as I would have thought. Most were thoughtful comments.

But last week, after a discussion with my good friend Gary Halbert of ProFutures, I realized I need to do a better job of giving you my rationale. Making such a serious statement needs more thoughtful analysis than I did in that letter. I sometimes forget that you might not be taking notes on my pearls of wisdom, so I should have reviewed the reasons for the call. I have touched on most of these points over the last year, so I will not go into great detail, but let me line up the dominoes and see which way you want to push them. I will also make a case as to why I could be wrong.

1. I constantly write about Price to Earning Ratios. Today, the S&P 500 is at a P/E ratio of 28. That is almost twice the historical average. The NASDAQ numbers make the S&P 500 look sane. The Nasdaq 100 index has a market-cap weighted price-to-earnings ratio of 102, based on projected 2001 earnings (source: TheStreet.com.) And those projected earnings are unlikely to be there, in the opinion of many analysts, including myself.

I read no one who suggests that we are going to see bubble era type growth numbers in the economy, now or in the next year. Now the mantra seems to be that the effect of the rate cuts will stimulate the economy in the last half of this year and the recession will be over quickly. The cheerleaders tell us to ignore the problems of today, "If you look to the future everything will be alright." Of course, they said the same thing when the NASDAQ was at 5,000.

They may be right, but as I will outline below, it is definitely NOT clear we are out of the woods, and if we are not, the risk to your stock portfolio could be great.

These markets are once again priced for perfection. At the latest Berkshire Hathaway meeting, Warren Buffet sounded a warning that he thought stock prices were too high. Bonner quoted him: "The probability of us achieving 15 percent growth in earnings over an extended period of years is so close to zero it's not worth calculating,' said Buffett. 'Nor do we think any large company in the United States is likely to (post such growth).' Of the Fortune 500 firms, he added, only 2 or 3 might be about to sustain 15% annual growth rates for an extended period. 'Fifteen percent (return on stock investments) is a dream world,' he warned..."

2. Professor Robert Shiller clearly demonstrates in his book, Irrational Exuberance, that investors have never shown a profit after ten years once these nose-bleed P/E ratio heights are breached. Not once. Get this book and read it before you invest another penny. Maybe we are in a New Era, but it still feels like the business cycle is alive and well. More about this later.

3. I have written a lot about the Yield Curve. Historically, it would suggest that we will see a recession begin this summer. Not the first quarter, and maybe not even this spring, although we certainly could see it begin this quarter. Stock markets drop an average of 43% during recessions.

Forget the NASDAQ. That was a bubble, and as I have written extensively, that 50% drop had nothing to do with a recession. It was mass insanity or greed or momentum investing gone amok. It should drop another 20%-40% if we go into recession.

What worries me are non-tech stocks. They have not fallen by anywhere close to 20%, let alone 40%. If you measure just non-tech stocks, you could make a strong case that we have yet to enter a bear market.

As we will see in a minute, the numbers tell us we are headed to a recession, though how long or how deep is anyone's guess. Will we see a drop in the market if we get into a recession? History tells us yes.

4. From time to time, I mention Dick and Doug Fabian's well-known investment program. It is a simple trend-following program, but over time, it works. The premise is simple. When the market is above its 39 week moving average, they are in the market. When it is below, they exit to cash. While the system does not always avoid large drops, it has beaten the S&P 500 over the last 20 years. Today, the S&P 500 is below its 39 week average. It is warning us there may be problems ahead.

5. Bear markets do not usually begin with a 180 degree reversal in sentiment. They develop slowly and tortuously. Ken Fisher in Barron's said it well. After he shows that institutional forecasters have become very bearish after the recent drop in prices, he says, "If we were simply going through a bull market correction, forecasters overall would become more pessimistic and advocate increased caution. Not this time. Their behavior was the very sign of a bull market having turned into a bear market. Increased optimism in the face of a strong market jolt downward means the pros and their friends spent or caused to be spent every bit of cash they could. This leaves no future demand to push stocks up."

Read that again. It is important. The Dow, as an example, has been bouncing off 11,000 for 5 months. In February, it made several attempts to cross 11,000 and failed before we saw a drop to almost 9000. In bear markets, bullish investors run through their money in the hope the markets will break above the next barrier. And when it fails, there is no more money to stop it from falling to further lows.

Before we get to a real bottom, we need to see this optimism, at a minimum, turn neutral, if not become outright pessimistic. As I wrote last week, my proprietary sentiment numbers based on dollar flow have been extremely high. In fact, they are much higher now than during most of the bull market of the last decade. Part of that is because the largest share of the market is now dominated by smaller traders and investors, instead of large institutions. Lately, the institutions which do remain have turned very bullish. Everyone, large to small, seems to be investing on the belief that Greenspan's rate cuts will turn the economy around within a few months.

6. As numerous writers have pointed out, if last month was a bottom, it is the highest bottom in terms of P/E ratios in history. Never has a market bottomed at a P/E ratio of 22, which is 50% ABOVE average levels. If we were to get back to the historic average of 15, we would see the S&P 500 close to 750. I suppose someone could do the research, but I would be surprised if a bear market ever stopped at the historic averages. Usually they blow right past the historic averages. If history was our benchmark and we do enter a recession, we would expect the S&P to drop to 500, the Dow to 5,000 and you don't even want to know about the NASDAQ. I don't think we can apply history, as we clearly live in different times, but you should be aware of what you are fighting when you are in the market.

7. Let's look at the 'risk to reward' of investing. At these market levels, how much higher are we likely to go as we face the uncertainty about a recession? Do you seriously think the DOW will go to 12,000 this year, which is just 10% from here? Can we close the year close to all-time highs of 11,500, which is about a 6% gain? Can it do this at the high valuations we currently have? Can it do this in the light of reasonable expectations that profits will likely fall and not rise?

If the S&P 500 were to rise 10% to almost 1400, we would have to see forward P/E ratios remain above 25, assuming earnings growth of 10-15% from 2001. (I assume analysts will continue to drop current earnings till they get to $50. They are close now.) Even if we did not, that means we will be at historically high P/E ratios.

On the other hand, what if we have a real recession? Not just one quarter of mild retrenchment, but a serious 3-4 quarter recession. Our economy has a lot of excess that we have built up over the last 18 years: record personal and corporate debt, a negative savings rate, a lot of inventory and a mountain of excessively high expectations. We have been dodging the bullet for years. If you are in the market, you are betting that we will do so once again.

Is it feasible that we could see a 20-30% or more drop in the stock market in the middle of a recession?

It seems to me we are risking 30% or more of our assets for a 5-10% gain.

I just don't like the risk to reward ratio. If I am wrong and you take my advice, you will miss out on a 5% gain. And maybe not even that much, as it will become clear within a few months whether we are going into a recession. If I am wrong, then I will suggest we get back into the market.

Ask yourself the following question. Which will affect your lifestyle more: not gaining 10% in your portfolio or losing 30%?

( I am assuming you will do no worse or better than the market indexes.)

I Have To Be In The Market

Now, there are some of you who want to be invested in the market. You feel that a portion of your assets should always be in the market. You can make a case, and a good one, that some portion of your portfolio should always be in the market.

The best case I have seen for today's economic climate is for stocks that represent good value, or funds that specialize in buying value stocks.

I would suggest that you stick with solid value funds or stocks at this point. By value, I mean companies with solid earnings and low P/E ratios. Look for high and increasing dividends. I am going to ask my friend Lynn Carpenter of the Fleet Street Letter to give us some good value stocks. I like her methodology, and she does have a knack for finding value. I will also suggest some value funds in a few weeks. You could purchase those after we see some type of correction, rather than getting in at the current highs. (That should be a hint that I don't think the bottom will come in the next three weeks.)

In my humble opinion, buying Intel or Cisco or any other high P/E ratio tech stock at these levels for a buy and hold portfolio is simply spitting in the face of history. It does not make any difference how good these companies are, or how much their stock has fallen. The issue is value.

I also understand there are other reasons to hold stocks. If you are elderly and have massive gains in a stock and want to pass that gain on to your heirs, you can make a case for holding. But I would strongly urge you to get tax counsel on your portfolio and see if the taxes you would pay justify the risk you are taking.

So, let me repeat. I think the risks of holding stocks today is high. There are alternatives. For instance, I still like bonds. They have bounced back up about 4% in the last few days. Frankly, I hope they go back down for a month or so as we are getting a lot of new clients into bonds and I want the clients to get into the program at the best point possible.

You are all adults, and are responsible for your investments. I am just trying to give you some "heads-up" on what I feel is an abnormally risky situation.

The Numbers Don't Look Good

There have been so many numbers out this last week, it is hard to know where to begin, so let's just plunge in.

Consumer Confidence is dropping. Pick a poll, any poll.

Every consumer confidence poll, and there seem to be an endless stream of them, is down and dropping each week. I have made it a repeated theme that consumer confidence is directly related to job security. So when we look at the numbers below, we should not be surprised to see confidence dropping.

According to the conventional consensus among economists, employment was supposed to go up this week. Employment went down a big 223,000 jobs. It was the largest decline in ten years. Jobless claims went up to 421,000, the highest reading since 1996. If memory serves, there was a big auto strike, which sent the numbers up then. On a "real" basis, you have to go back a lot further. Unemployment is now up to 4.5%, and some are expecting it go to 5%.

From Weldon: ---Challenger reported record layoffs in April, marking the fifth straight month of 100,000+ US layoffs. The April total of 165,564 layoffs is FOUR TIMES the level seen in April-00. For the YTD, layoffs total 572,370, up HUGE from the April-00 YTD cumulative layoff total of 179,144.

Exports and Imports Drop

Looking at the numbers from the National Association of Purchasing Managers, we find exports dropping and imports dropping even lower. We are shipping less and we are buying even less. But that should not surprise us. Unemployment is rising in the rest of the world. Weldon regularly shows data from other countries clearly showing a slowdown in trade. Even in Europe, where their leaders kept telling themselves they were immune to a US led slowdown, we are beginning to see signs of real trouble.

I told you early this year that we would see rate cuts below 4%. It now seems that I may be an optimist. I think we will see at least another 100 basis point in cuts and maybe another 150. If not, then why is the Fed expanding the money supply by record levels? We are seeing faster money growth, and no impact on inflation, than at any point I can remember. If we saw money supply expansion like this in the 80's, gold would be back up to 800 and interest rates at 20% almost overnight. We were all money supply hawks back then. Now we just yawn and hope he expands it more.

It is not going into loans. Banks are pulling back, and indeed are having to set aside more money as reserves against increasing loan losses. It is not going into increased capital expenditures, and is not yet having a major impact on corporate bottom lines.

Is it once again going into the stock market, just as it did in 1998 and 1999? Could Greenspan be holding the stock market up by fueling the money supply? Will it continue to work?

I don't want to be gloom and doom, but I could go on for pages. I mean LOTS of pages.

I cannot tell you how many reports and newsletters I read in preparing this weekly letter. I don't want to know. I try to read a wide variety. But about the best news I get lately is that each bit of bad news makes rate cuts more likely.

If this is a classic bear market, we can expect this market to keep churning, trying to make it over the next hill, with each attempt a little more feeble until the bulls spend all their ammunition and the market drops to below 9,000 on the Dow and below 1100 on the S&P before once again trying to climb out of the pit. It will NOT happen overnight. It may churn for a few weeks, or it could charge through 11,000 and 1300 in one final gasp and then drop after that. Anything is possible, although I expect that we are within a few percentage points of the top, if not there already.

Now, could I be wrong about a recession and a bear market? You bet, and I hope I am. It is bad for families and business, mine included.

Here are just two scenarios in which I could be wrong. Many readers will be able to think of more, I am sure. And the First Law of the Curve in the Road says whatever happens will be different than any of us think.

1. Investors, having been taught to buy the dips, do something they have never done before. They keep buying stocks on dips right through a very short and very mild recession, anticipating the recovery and holding the stock market up in a volatile roller coaster ride, but the Dow never drops much below 9500 and never gets much above 11,000, with the S&P trading in a narrow band of 1100 to 1300.

Consumers, seeing the market hold up, do not start worrying about their jobs and keep right on buying, knowing they can always get another job; if not right away, then pretty soon, so there is no need to change their lifestyle drastically.

2. The rate cuts take effect sooner than ever before in history. Instead of the 9-12 month usual minimum which would put us late this year for the bottom of the recession, it could happen this quarter. Businesses, sensing the recovery, start to expand in anticipation, making large capital expenditures and hiring new employees. Investors, seeing the employment numbers reverse and getting positive earning pre-announcements, start on a new buying binge.

These and other more positive scenarios COULD happen. I hope they do happen. Anything is possible. But to be invested in the market today is fighting history. Those who believe we have seen the bottom of the market in April cannot point to another time in history and say, "See, today is just like then!"

Salmon who swim upstream may get there, but they have to fight the bears on the trip and die when they arrive anyway.

It is time to head off to church. This has been a busy weekend. It is our wedding anniversary. Right after church, my bride and I are headed off to Hilton Head for a week of R&R. Believe it or not, she arranged for the destination for our annual honeymoon even though she does not play golf! I am reminded once again what a lucky man I am, in more ways than one. Then I am off to Denver for a conference on May 14-15. If you are in Hilton Head and want to play some golf, call the office at 800-829-7273 and leave your number. If you would like to meet in Denver, I will have some time as well.

You will be getting a special edition of Millennium Wave Online at the end of the week. Don't miss it.

Your hoping to break 100 Analyst,

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