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October 13, 2008

Weekly Wrap-Up: Valuation Doesn't Matter
by Adam Oliensis

Dear Speculators,

The following article was originally published at The Agile Trader on Sunday, October 12, 2008. If you would like a free one-month trial to our twice-daily service, please click HERE and then click the red "subscribe" link at left.

Paul Volcker, the Fed Chairman from 1979-1987 (immediately preceding Greenspan), was interviewed on Charlie Rose this past Thursday. In the introduction to the piece, Rose quotes an analyst as saying, "people have lost faith in everything. We're dealing with an investment community of atheists right now. Valuations no longer matter." (Note: Nothing against atheists here. I might even be one, depending on how loosely or tightly one grips the concept of "theism." The use of the word, "atheists" is, I think, intended not in a strictly religious sense, but at least a little ironically, to describe the lack of faith in the financial system.)

Let's focus on that Rose's last sentence: Valuations no longer matter.

Obviously, in current circumstances, that statement is intended as a negative. Something along the lines of, "It doesn't matter how cheap the market is, it can still go lower. And its earnings (valuation) have nothing to do with how the market is priced."

To anyone who was in the markets during the heyday of the Tech Bubble, this is an interesting mirror image of what was going on back then. Around 1999, the conventional wisdom was that you didn't value a Tech stock based on its earnings or potential earnings. Those "didn't matter." Valuations were based on eyeballs, page views, and other equally evanescent metrics. "Valuations no longer matter." I never thought I'd hear that expression again. Least of all with precisely the OPPOSITE connotation with which it was suffused just nine years ago.

I suspect that ultimately the phrase's current meaning will turn out to be as impressive as a contrarian indicator as it turned out to have been just 9 years ago. Back then, "Valuations don't matter" represented a zenith of euphoric bullish sentiment, and I believe that in the future we'll look back on current usage as a nadir of desolate bearish sentiment.

As expensive as the stock market was back in 1999, it's probably that cheap right now.

For the moment, however, "dislocation" is the operative market theme.

The underlying problem is in the credit markets, as a function of excessive debt and the sharp, fast depreciation of collateral (of home prices, and consequently of mortgage bonds) on financial companies' books. We can get a visual representation of just how seized up is interbank lending from the 3-Month TED Spread (difference between 3-Month LIBOR and 3-Month Treasury yield, representing banks' relative hesitancy to lend to other banks), which is now at 4.636%.

As you can see the TED Spread normally abides well below 1%. But since late September '07 the Spread elevated above 2% on 3 occasions prior to the current moon-shot up over 4%. This last, despite a host of policy accommodations including the Big Bailout Bill, which passed in Congress ($700B to support the prices of distressed assets), and a 50 basis-point coordinated rate cut by the Fed and a large number of other Central Banks last week.

This weekend global leaders in Europe and Asia, as well as other parts of the world, are meeting to discuss further coordinated action to address the crisis in global financial markets. As of Friday, the G-7 was not able to express a clear or detailed approach, and there is much anticipation and trepidation regarding what will (or will not) be announced prior to Asian markets' opening on Monday.

Turning to the earnings picture in the stock market, the SPX (black line below) has disconnected from the trends all 3 of our Earnings per Share lines (blue, yellow, and pink).

It's not that the trends are particularly positive (trailing earnings and reported earnings are negative, and the consensus estimate for forward 52-wk earnings is in a flat range), but the drop down from the SPX 1200-1250 range down below 900 is a character change of a magnitude and speed unlike anything seen even during the big bear market of '00-'02.

Reported earnings (pink line) remain at a level that's 116% above their '01-'02 bear-market low. Trailing operating earnings (yellow line) remain 75% above their bear-market trough. And the consensus estimate for forward operating earnings (blue line) is 90% above its late-'01 low. Meanwhile the SPX has dropped down below 900, and is just 12% above its low weekly close of '02. That has dropped the Price/Earnings Ratios of the SPX down to extremely low levels.

The PE on forward operating earnings (blue line) is now at 9.1. The low on forward PE at the 2002 bear-market low was roughly 14.5. The PE on trailing operating earnings (yellow line) is now 13.3. That's the lowest reading on the yellow line since 1989. But, in 1989 the 10-yr Treasury, which now has a Price/Dividend ratio of 26.4, had a P/D ratio of about 12. So, in 1989 stocks and bonds were much closer in value than they are now. Right now stocks are about half the price of bonds, or, put the other way around, bonds are twice as expensive as stocks, as money continues to seek the safety of Treasuries, and flee from risk assets.

The yield on SPX forward earnings is currently around 10.98%. The 10-Yr Treasury yield is 3.745%. The difference (10.98% - 3.78%) is about 7.2%. We call this difference Equity Risk Premium (ERP), as it represents the excess yield (relative to Treasuries) that investors demand in order to assume the risk of investing in the stock market. At 7.2%, ERP has hit its highest level since at least 1960 (that's as far back as our database goes). Since 1960 the median ERP has been 0.32%, very close to zero.

At 7.2% ERP is now higher than during the Cuban Missile Crisis (1962), higher than when Nixon resigned (1974), and higher than when inflation spiked up into the mid-teens (peaking in early 1980).

Since 9/11 the median ERP is 2.08%. If we make the provisional assumption that that's an appropriate adjustment in a riskier post-9/11 world, then we can make a Risk Adjusted Fair Value (RAFV) calculation on the SPX.

RAFV = F52W EPS / (TNX + Med ERP)

Where

F52W EPS = forward 52wk earnings per share
TNX = 10-Yr Treasury Yield
Med ERP = post-9/11 Equity Risk Premium

RAFV = $98.73/ (3.78% + 2.08%)
RAFV = 1732

As you can see, the disparity between the SPX price and the RAFV price is now 833 SPX points, by far a larger difference than at its widest in 2002, when RAFV was below 1400 and the difference was less than 600 points.

This, following the worst week in the Dow Jones Industrials' history, dating back to at least 1915.

On a week-to-week closing basis, the Dow fell more than at any time in 1929 or 1987, dropping more than 18%.

Of course, the longer-term question is whether we are in an early phase of something that will ultimately look more like the crash of '29, from which it took the Dow (and the US economy) decades to fully recover, or whether we're in something more like the crash of '87, which turned out to be not much more than a blip in a long-term uptrend. The answer to that question will hinge on whether, to what extent, and how quickly policy initiatives are able to gain traction and alleviate the unprecedented stresses in the credit markets.

We've never had a credit crisis like this one, so, as I heard one commentator say on a Sunday morning talk show today, there's no playbook, they're drawing up plays in the dirt like a sandlot football team.

Clearly policymakers are making an effort to flood the system with liquidity, as evidenced by the surge in M2 growth (the broadest measure of money supply still published by the Fed) in late September (the latest data available). This last chart plots the 13-wk annualized growth of M2, set 8 weeks ahead, against the SPX.

Most of the time there is a very informative correlation between the 2 series when plotted like this (local peaks and troughs sync up smartly). However, as you can see, in 2002-2003 it took the stock market quite a while to respond to the sustained above-trend growth in M2, and the correlation between the 2 series was thrown out of wack from that point into 2004.

Will the market respond to re-liquefaction in the context of the current crisis? Again, we have an unknown, though there is reason to believe that it will (it has done so before following crisis situations, even if somewhat sluggishly).

As of about 2pm EDT, various news sources report that EU leaders are meeting in Paris. Britain has announced that it will take ownership shares in flagging banks (US Treasury Secretary Paulson has already reversed course from his initial position and said that part of the Big Bailout will involve similar action). French president, Sarkozy says that European countries will offer an "ambitious and coordinated plan" that is more far-reaching than the G-7 plan presented on Friday. Germany is also planning on supporting banks and insurance companies.

The issue at hand is trust, or a lack thereof, among counterparties in the financial system. But in a more specific sense, the question is whether sufficient capital and liquidity can be injected into the system to reestablish a sufficient probability of profit to outweigh the possibility of loss. Just where that "tipping point" is...well, that's an unknown at the moment. But it does appear that governments around the world are making their best efforts to address the problems.

Since we're in uncharted waters, it's tough to predict where the tipping point is in the short term. If we do find it, however, "popping" the market's "dislocation" back into joint should generate a very sharp snapback rally off these very extreme lows. Moreover, should the financial system get re-liquefied and re-capitalized, the odds would then favor a very very positive market return over the next 2-3 years.

If you would like a free one-month trial to our twice-daily service, please click HERE and then click the red "subscribe" link at left.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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