June 13th, 2006
I’m finding that it’s much more difficult to consistently write about the market when it’s heading south than when it’s perking along in bull mode. While I’ve put on nearly 30 short positions diversified across several industry groups over the past 3 weeks, it’s nerve racking knowing that while the sky’s the limit on the upside when you’re long, there’s a limit on the downside (although it can be swift, there’s a practical maximum the average stock might decline in any correction). So I sit here watching the CNBC ticker for any sign of a market reversal with my “finger on the trigger” ready to quickly cover those shorts.
I always said the “the market is like a steamship, it doesn’t turn on dime.” However, the past month or so has brought home the realization while it may be accurate when speaking about reversal to the upside but it’s clearly not applicable about downside reversals.
This correction, which began on May 10-11, was like someone turning out the lights; stocks have just fallen off a cliff. And some of the drops have been staggering in their depth and quickness. The average Homebuilders, for example, is down 30-35% since March 20 (see my March 7 post); the average Oil& Gas is down 20-25% since May 1; the typical steel stock is down 25-30% since May 10. It’s almost too sick to look at.
Jim Cramer, among others, began touting international stocks around the beginning of the year (remember his “pimping around the world”), probably because of a concern that US stocks were becoming overvalued. But foreign stocks, as represented by country ETF’s, had already been up huge for at least three years prior to last year end. In my December 30, 2005 post, I
included a table showing three year returns, often close to and over 100%; I wrote:
“If you believe that everything ultimately “converges to the mean”, then next year might actually see the beginning of a bull market in US stocks as as they begin catching up with foreign stocks that either show little growth or even declines.”
Foreign stocks continued their tear up until the day the lights went out (May 10, that is). It was then that all the commentators began searching for a causal explanation and came up with world-wide central bankers beginning to fight inflation as evidenced by rising gold and oil prices (but few explained it as finally these markets facing a correction due to the huge increases up to
that time …. because they missed the possibilities until the beginning of this year).
So when the lights did go out here, they, too, began to collapse. While the S&P 500 has declined 6.54% since May 10 leading to an essentially flat result for the year through yesterday, most foreign ETF’s erased significant portion of their gains up to that point:
|Country||Index/ ETF||Year to May 10||May10- June 13||2006 YTD|
Foreign stocks have a long way to go or we are going to be facing a bull market that might be as good as, if not better, than the late ’90’s …. when this correction ends.
I’ve written here a number of times about the concept of a “secular bear market”. I first came across this notion in a book (my son was kind enough to give me called Bulls Eye Investing
John Mauldin, in which Mauldin writes (even though it was in 2004, it’s just as relevant today):
“I believe we are going to single-digit P/E rations. I also believe it will take a decade or more, just as it did in the 1070’s and in past secular bear markets. During that time, earnings will grow and probably double or more (without having to be too optimistic). What happens in secular bears is that earnings grow and P/E rations drop. But it does not happen all at once. It takes time…..the level or returns correlates very highly to the trend in the market’s P/E ration….not on of the periods of strong gains occurred without rising P/E ratios.”
Mauldin is also emphatic that the next bull market can’t begin until the market’s P/E ratio approaches 10. So how are we doing? A picture (thanks to IBD) says more than words:
It feels strange for a “chartist” to speak about something as fundamental as earnings and P/E ratios but, I don’t concur that the momentum you find in a bull market can be sustained without the S&P 500 P/E ratio dropping further and then beginning to expand again within a sound economic environment. The current correction along with improved earnings has brought the S&P 500 down to 14.1 as of June 12.
Last night, Jim Cramer, hopefully sarcastically, answered the question of how do we know when we hit bottom by saying “when you’re stock starts turning around”. Duh! When I want to school that was called a “tautology” (according to Merriam-Webster, a “needless repetition of an idea, statement, or word”). So how much pain is there left before the a recovery can be sustained? If the S&P currently has earnings of approximately $85/share (yielding a 14.1 p-e at current prices), and it grows by 10% over the next 12 months to 93.5, and the P/E ratio continues to
decline to 12, then the index would decline an additional 8% to approximately 1122-1150, a level that happens to correlate with the next significant support trendline.