After an extended three day weekend, the markets reopened yesterday and sold off aggressively, closing at the lowest levels since November 20th. There have been many reasons proposed for the recent declines, including a buy the rumor sell the news mentality following the passage of the stimulus plan, a new fraud uncovered by the SEC, and very weak European and Japanese economic data.
Several strategists also reduced their 2009 earnings estimate for the S&P 500 to below $50, which would place the market’s P/E multiple at 16x – not expensive, but not entirely cheap either. It is important, however, to realize that for cyclical businesses, P/E ratios always look the cheapest at earnings peaks and the most expensive at the earnings troughs. Following a strict valuation approach here would mean buying when prices are high and selling when they are low, which would, of course produce disastrous outcomes. This is why it is important to consider “normalized” earnings when thinking of valuations rather than coming to hasty conclusions. What constitutes “normal” is of course open to a wide set of interpretations, but I certainly hope that the current environment doesn’t prove to be “normal” going forward.
On the banking front, Greenspan and some Republicans in Congress have actually been talking up the idea of nationalizing some of the nation’s banks. You could argue that with all of the government money in many of these banks already, they have been nationalized to some extent. The Geithner and Bernanke approach is to first find out the facts by sending in more regulators to look at the banks books and “stress test” them to see how solvent they would be if things become much worse in the economy than they already are. This approach makes some sense in that it may help everyone understand what the downside case might look like, which will be important information for the public markets to price troubled loans appropriately and thus implement an effective bad bank plan.
In spite of the declines, the S&P 500 has still managed to hold its November lows which are now 6% below current trading levels. Our short term investment play book continues to be based on the view that these lows should hold and that investors will be best served by buying and adding to positions near these lows rather than waiting for when it is emotionally easier to do so following a 30% bear market rally. We expect that repeated bear market rallies are likely this year, with hopes of a more sustained run likely occurring in 2010 as the economic fundamentals begin to improve. We would also note that the markets are unlikely to make a sustained upward move without the participation of financial stocks, particularly the banks. These entities are, after all, vital to the long term functioning of a healthy economy.