We note the continued sharp divergencies within the equity market insofar as valuations are concerned. As we have opined before, there are a number of very high quality equities which are very undervalued relative to their historic valuation ranges. At the same time, equities in economic sectors which are going from bad to worse, while attractive on their face, are increasingly dubious in the context of a sharp decline in future earnings implied by the deepening credit contraction. In point of fact, the measure of absolute valuation (p/e ratio) is contingent upon the actual earnings which will in fact materialize in coming quarters. It is the rising probability of a serious overall earnings contraction which has raised the risk level of the overall market very substantially, in our view.
Leaving aside for the moment the reality of two economies and two markets, which we continue to embrace, we assess the respective cases of the bulls and the bears in the CURRENT AND UNFOLDING ECONOMIC CONTEXT AS FOLLOWS:
--The bulls maintain that valuations are very attractive relative to historic norms. Their hypothesis is that the economic weakening underway will NOT develop into a serious recession. Indeed, many in the bullish camp assert that the economy is having a "soft landing" and will avoid recession altogether.
The bulls cite the FED rate cuts as a powerful bulwark for the market and as surety that a further substantial decline in equity prices will not occur. Consequently, what we have experienced is simply a bull market "correction," albeit a severe one.
The bullish case rests upon the favorable implications for stock prices of the current -- and prospective -- level of interest rates relative to the dividend yield of the market.
The bulls also cite considerable sentiment evidence which, interpreted in the USUALLY reliable contrary manner, indicates a high level of bearishness.
--The bears, in contrast, believe that a recession in coming quarters is axiomatic. Some believe that a recession is already underway. These recessionary expectations have serious negative implications for earnings. Rather than growing by 5 or 10 or 15%, as was expected until fairly recently, the bears look for a substantial DECLINE in 2008 earnings. If they are correct, then the p/e of the overall market is transformed radically -- from being at the low end of the normal valuation range to being deep in the danger zone.
Many in the bearish camp argue that it is too early to buy equities; that the "normal" pattern of a declining market coinciding with the early months of a recession will hold this time around. The more extreme bears worry about the possibility of a severe recession, or even a regression to a Japanese-style deflation. For these folk, a powerful decline in interest rates WILL NOT produce a bull market in equities, but will only serve as the accompaniment to a long-lasting bear market in stocks.
We, for our part, are very concerned about the ongoing economic downturn and its potential impact on corporate earnings. Still, there are businesses and there are businesses. Those in the healthier parts of the economy are unlikely to suffer serious earnings damage. However, it may be that this group is shrinking. It is difficult to swim against the tide, and the POTENTIAL SEVERITY of the current downturn has raised significantly the risk level of equities.
Of course, the growing obviousness of the deepening weakness has catalyzed the heretofore detached FED into intense action; it is also spurring government bailout moves.
We cannot offer any market prognostications. We simply do not know. We continue to believe that a focus on individual equities where earnings prospects are largely unimpaired, where valuations are attractive, and where solid dividends are offered are a reasonable port in the storm. Caution however is indicated: consider, after all, the collapse of the great banks, who have heretofore appeared to the naked eye to be bastions of stability, solidity, solvency, and a reliable and reliably rising dividend payout. Rarely have so many "experts" been so wrong -- and that is saying A LOT.
