I can appreciate that people are upset about losses in the stock market, but I can’t say I didn’t tell you so. You can lead a horse to water, but you cannot make him drink comes to mind.
What I find humorous about all of this is the suggestion that the selling in the market was driven by panic and fear. Read my lips, "the move down was quite Rational!" There was nothing irrational about the correction in values.
It took some doing, but the market finally realized that the economy would be weaker than expected going forward. The incessant calls for a bottom in the housing market were trumped by a complete collapse of the financial sector.
What other conclusion could we surmise given the trillions of dollars in assets that were suddenly caught in a vortex of declining valuations? Given that the financial space generally leads the market any unbiased observer would have realized that stocks were headed lower.
Interestingly, it is after the fact that irrationality is now creeping into drama. Many investors are rightly frustrated and are now acting on emotion instead of logical thinking. Even the talking heads on television are showing a defeatist attitude and mutual fund outflows are rising by the minute.
No wonder so many are calling for a bottom. As a contrarian investor behavior during a crisis is a key indicator for a reversal. In this case the behavior today is starting to get a wee bit irrational.
I agree with Buffett in that the time to buy is when nobody wants to own stocks. At the moment more and more investors that I talk with seem to want nothing to do with stocks. They are beaten down.
With that attitude I should be celebrating. History is indeed full of times like these whereby huge rallies ensued in the wake of disinterest in stocks. If anything I should be hoping for more pessimism.
The more negative people become the greater the returns on the back side. Of course it is not in my nature to root for more negativity. Instead I want to spend some time talking you off the ledge.
Let’s start by making a simple observation. Have you noticed that much of the discussion in the midst of this bear market is focused on fear? There is very little in terms of concrete comments on valuations.
Instead we are being inundated with talk about the economy being in recession here and across the globe. We hear about deflation and de-leveraging and how such a state will be bad for stocks.
Ultimately many of the things being bandied about are important, but they pale in comparison to valuation. At the end of the day it is…
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…valuation that dictates where the market goes especially in the long run.
With the market lower valuations are more in line with future expectations of corporate performance. At the moment, the estimate for the S&P 500 operating earnings in 2008 is 76.73. The forward estimate for the S&P 500 in 2009 is 103.75.
Historically the average forward multiple to operating earnings is 12. At the end of this year, assuming we hit the estimate, the S&P 500 index should be trading at or around 920. Since we are at 930 as I type this I would say the market is fairly priced.
On a forward basis a 12 multiple of the expected 103.75 puts a value on the index at 1,245. Assuming all goes well next year and we meet expectations, historical valuation models suggest that the market could potentially rise by more than 20%.
That would be beefy returns indeed and not what is currently expected by the pessimists.
The rub of course is that all is not going as expected. The 103 number is likely to be adjusted lower as the recession grips consumers in a way that drastically reduces expenses.
That is certainly a likely outcome and I too believe that the recession will be longer and deeper than expected. So let’s take that 103 estimate and reduce it by 20%. Doing so puts us back to where we are expected to finish this year.
Again with the S&P 500 at 930, we are fairly priced even if earnings are reduced from current expectations. In my mind the worst thing that happens from here is that stocks bounce along the bottom.
The best case scenario is that the recession is not as deep as expected. If so, stocks might go trade even higher than historical norms. That would be a fantastic outcome.
Much is uncertain at the moment and I am in no hurry to deploy capital into this market. My only point in all of this is that now is not the time to sell. The time to panic was in early October.
Don’t panic now.
This article was written by Jamie Dlugosch, contributor to InvestorPlace.com. For more actionable insight like this, go to: www.InvestorPlace.com and check out:
