We are NOT FORECASTING a waterfall-type decline in the stock market in coming weeks or months. However, we are not precluding it either. The RISKS have risen for two possible market scenarios, in our view:
Our growing concern is based upon the continued state of denial of a wide spectrum of "informed" and "professional" opinion about the prospects for the American and global economies, the continued success of the generality of brokers and "financial advisors" in dissuading the mass of investors from selling, and clear signs that the substantial prospects for more significant deterioration in the banking system are being widely ignored. The principal talking point for the bulls is the relationship between stock valuations and interest rates, i.e., the "Fed model." The price/earnings multiple of the S&P 500 is approximately 17-18x lagging 12-month earnings, as things currently stand. Bulls had been forecasting improved earnings in 2008, and a consequent reduction of the p/e multiple to an even more attractive level, even as competing bond yields continued to drop. A very nice scenario indeed. Unfortunately, an ugly reality is beginning to obtrude. This reality is the prospect of DECLINING EARNINGS in 2008, and possibly VERY SHARPLY DECLINING EARNINGS. Anyone can plug in any number one wishes. If the distress in the banking system continues to mount, with the domino-like impact of an intensifying credit contraction on the economy and on corporate earnings, the RELATIVE VALUATION PICTURE (ie., the earnings yield of the market relative to the interest payout of Treasuries) goes from attractive to ugly. This, in fact, is what we expect. The bulls on the economy have been WAY too bullish; the bulls on the credit contraction have been WAY WAY too bullish; the bulls on the banking system have been too bullish by ORDERS OF MAGNITUDE. Now prices, of course, do not bear ANY NECESSARY ARITHMETICAL RELATIONSHIP TO VALUE. It is the PSYCHOLOGY OF THE MARKET which determines whether the generality of investors are willing to pay 15x earnings, 20x earnings, 40x earnings (remember the spring of 2000?). On the other hand, market psychology could lead the generality of investors to be unwilling to pay more than 14x, or 12x or 8x. Who knows? The central risk in the equity market at this time, in our opinion, is that market psychology -- and the price/earnings valuation this psychology is currently supporting -- is in flux. The possibilitiy of a sharp decline in market optimism could have a dramatically negative impact on prices, regardless of what charts or models may suggest. Market psychology is increasingly vulnerable, we think, as continuing worrisome news about the banking system, individual marquee companies, and the overall economy continue to surprise on the downside. If the cumulative impact comes in one fell swoop, the path is open to a waterfall-type decline; if it impacts more gradually, with each downward ratchet being accompanied by a fall in the market, then the longer-lasting type of bear market would likely ensue. Of course, it may be that we are being too pessimistic. |
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