God is a Capitalist

Wednesday, January 20, 2016

Poking the bear - what happens next to the market?

The S&P is down about 9% for the year and 10% from the highs last year as of this writing. By the time you read this, the index may be even lower. The bear has been hibernating for seven years and may be waking up. If so, he’ll be hungry for your nest egg. 

Technicians will be looking for the lows of last year for support as if nothing has changed. But a lot has changed. Profits for the fourth quarter of last year are expected to fall over 5%, according to data provider FactSet. And even if you leave out the disastrous energy sector, profits are expected to be flat.

China, Brazil, Europe, Japan are in worse shape. US manufacturing has been in a recession for months. Oil, gas and mining are in recessions. We are beginning to see the effects in the consumer sector as retail sales from the Christmas season sunk below those of last year.

This is a good time to look at where we are in the business cycle using insights from pages 105-107 in my book Financial Bull Riding:
Joseph Calandro, Jr., a managing director at PricewaterhouseCoopers and professor of finance at the University of Connecticut. .. combined the insights of billionaire investor George Soros with those of the Austrian Business Cycle Theory in his book Applied Value Investing to investigate the rhythms of the market’s bucking cycle over time. Soros referred to the relationship between the performance of a company and its stock price as one of reflexivity, meaning that not only did fundamental information such as profits determine stock prices, but those prices influence the performance of the company...
This reflexivity, or the feedback between a company’s stock price and its profit performance ensures that most of the time price reflects fundamentals. However, on occasion the feedback loop gets broken and prices can diverge from fundamental value. Calandro reproduced Soros’ graph depicting the cycling of stock prices and earnings per share as a proxy for performance.[1]

Investors can see from the graph that often stock prices begin to decline before profits fall. But it’s more likely that profits begin to fall and that triggers a revaluation of stock prices by investors. That’s what has happened over the past few months.

If this is the big bear that we have been waiting for, then we can expect profits to continue to fall because profits tend to continue to decline in a recession once they begin falling. Two things are happening together: 1) stock prices dive with profits even if risk tolerance as measured by PE ratios remained the same, and 2) PE ratios are falling as risk tolerance shrivels. Stock prices will chase diving profits until they bottom out below a price that profits would justify at an average PE ratio. That would be somewhere near a 40% decline from the peak set last year.

For a few weeks media pundits will try to reassure investors that there is nothing wrong. The economy is sound. Employment is increasing, even though they know employment is a lagging indicator. GDP growth has been small, but it's not negative. So the plummeting stock market is irrational. That arrogance will turn to hysteria as the market continues to dive and the pundits will demand the Fed and Washington rescue them. Successful investors will have retreated to cash, gold or medium-term treasuries and can observe the hysteria from the comfort of their recliners.

Then when hysteria is at its worst and TV pundits are certain we’re all gonna die, then we can quietly buy back the market at great blue-light specials and watch our nest eggs swell as the market recovers. Of course, a market rebound may be a year and a half away.

[1] George Soros, The Crisis of Global Capitalism, (New York: Public Affairs, 1998), 52, in Calandro, Applied Value Investing, 112.

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