Second Quarter 2002 Newsletter

Market Conditions

 Question & Answer

How Low Might The Stock Market Go?

In an emotionally driven market there is no way to know for sure. When greed was out of control, the popular stock market averages (e.g. the S&P 500) went far beyond what rational analysis would have forecasted. We must be cognizant of the possibility that the same irrationality can work on the downside.

The trouble is that emotion is not so easy to analyze. And just as there were optimistic analysts who stepped forward to defend even higher stock levels, there are now pessimistic analysts making the case in support of much lower levels. That they are there making the case doesn’t make them right. As for us, we are more comfortable analyzing economic fundamentals than assessing market psychology. So, in attempting to provide some perspective on this question, our approach is to make historical comparisons of several types of data in order to provide a frame of reference.


As of Friday’s close (7/19/02), our basic valuation model suggests stocks are now 42% undervalued. At the end of the last big bear market (1973 and 1974), stocks bottomed at a 55% undervalued level. An 8% drop would get us to that level. But if interest rates drop further, as they probably would if stocks continue to decline, it would take a smaller of a decline. We also took a look at the Fed’s stock valuation model. It shows the stock market as 31% undervalued as of 7/19. At the end of the 73/74 bear it measured stocks as 36% undervalued.

Absolute Decline

As of Friday 7/19 the S&P 500 had declined by 45% on a price basis. During the 73/74 bear market the S&P 500 dropped by 48% (but it did have a higher dividend yield). Before that it was the 1930s’ depression period when we last saw declines larger than the decline in the S&P. As you know the NASDAQ has fared worse and is now down 74%. The last great bubble before the NASDAQ was the Japanese stock market. That market dropped 57% over 30 months (and has remained in a trading range for another ten years and counting.) There are significant differences between the U.S. and the Japanese market, though. While we have concerns about our real estate market, the Japanese real estate market was a massive bubble, and Japanese stocks were even more overvalued than U.S. stocks at the peak. Japan’s banking system was and remains sick and the government has not been aggressive in reforming it. The U.S. has a history of being much quicker to “take our medicine” when we need to, as was the case in the S&L crisis.

Length of Decline

The current bear market started two years and four months ago. That makes it longer than any U.S. bear market since the depression years.

Technical Factors

We do not rely heavily on technical analysis in our decision-making because we don’t do market timing. However it is true that the end of most bear markets are characterized by large declines on very high trading volume. On Friday, July 19 the market was down big on very high volume.

How low might the market go? We can’t say for sure but by all the above measures we can argue that this bear should be nearing an end. However, we don’t have many secular-type bear markets to study so we hesitate to pound the table with enthusiasm. Moreover, it’s true that the overvaluation was at a record level suggesting the possibility of an equally strong overreaction on the downside. We can’t say with certainty that stocks won’t decline and become even more undervalued. But valuation levels are now very attractive based on our analysis.

But Can We Believe The Valuation Measures?

Recently we have said that interest rates are so low that valuations are deceiving. A relatively small blip up in rates would have wiped out the valuation gap. However, after a huge drop in stock prices so far this month that is no longer the case. Even if interest rates rose a full percentage point, at current levels stocks would still be more than 10% below fair value based on our assumptions.

What About Earnings? How Can We Be Confident About Valuations If We Can’t Measure Earnings?

It’s likely that there will be more earnings restatements in the coming months as more companies come clean on aggressive accounting techniques. Despite this expectation we are fairly confident that current and anticipated earnings will support higher stock prices. There are multiple reasons for our confidence:

Normalized earnings

This measure is based on reported earnings (not pro forma) and looks at average earnings over five years including the forecasted earnings for the next 12 months. Valuations based on normalized earnings (we use a P/E based on normalized earnings and compare it to interest rates) are at the cheapest level since 1980.

Trend earnings

The earnings collapse just experienced was the biggest deviation from the trend of long-term earnings growth since the 1930s. Over the years big negative deviations have triggered big positive deviations and most of the time these were sustained for a number of quarters and followed by more quarters of above-average growth. The current earnings level is significantly below where it should be based on the long-term earnings trend. We believe the earnings collapse and expected snapback is a bigger variable than expected restatements.

Real Profit Growth

Over the past 50 years, almost every time real (inflation-adjusted) earnings growth collapsed over a trailing five-year period, very strong real growth followed during the next five years. The only exception was in the inflationary 1970s. The earnings collapse this time was the worst in the 50-year period. Profit growth has usually been very strong coming out of recessions but the period following the 1990 period was an exception.

There Is So Much Bad News Out There-Isn’t It Possible That This Bear Will Be Much Worse Than In 73/74?

This bear market is now within a whisper of surpassing ’73/74 so at this point we’d say there is a good chance it could be worse, at least for the S&P 500. The real worry is whether it will be much worse. Again, we can’t say for sure. But the fact that there is lots of fear based on real problems (economic risks and the terrorism wildcard) doesn’t mean we are due much more downside. Remember, bear markets end at the point of maximum pessimism, when fear is greatest. And at a bottom it will always feel like the stock market is about to drop another 20%. Doom and gloomers will get lots of exposure in the media. It is around this time that most of the selling will be done so that a small amount of buying can drive stock prices higher.

Remembering 1974 is useful. We had Watergate and Nixon’s resignation, the Middle East oil embargo, surging inflation and recession and a discredited Fed that all combined to create a massive pessimism. A Business Week writer wrote in the 9/14/74 issue”…the flight of individual investors and the breakdown of the markets foreshadows the end of the capitalistic system as we have known it.” (During the fourth quarter of 1974 the stock market delivered a positive return and the bear was over.)

Certainly it is possible the pummeling could intensify even more if the worst-case scenario plays out. If the housing market reverses, consumers cut back on spending and businesses hold off on investment, and we end up with a debt-induced deflationary period, stocks could still drop a lot. But that does not seem to be a high-probability outcome. The banking system is healthy at this point in the cycle, loan delinquency rates are not high and corporate profits are recovering. There are always risks of bad things that could result in temporary losses in the stock market. But in bear markets investors tend to see the glass as half empty just as they see it as half full in bull markets.

What About The Accounting Shenanigans?

We believe there will be more bad headlines and a number of restatements. However, we don’t believe most corporate managements are dishonest. And as noted above, though we can’t be sure, we now believe earnings are so depressed that a cyclical rebound is likely to offset earnings restatements. We also think that with politicians and the media focused so heavily on this issue, and with CEOs now having to sign off on financial reports over the next few months, the remaining misdeeds will be quickly exposed. It may be quite awhile before investor confidence in corporate governance begins to rebound and that may delay a return to fully valued multiples. But, we don’t think it will be a barrier to a market rebound when selling pressure subsides.

Does It Matter Where The Bottom Is?

For investors who can’t afford any more temporary losses the bottom does matter. However, for long-term investors whose lifestyle can absorb more short-term damage, we believe stocks are at levels that are very likely to deliver good returns over the next several years and very possibly quite high returns over the next six to 18 months. We can’t say with certainty, but based on our analysis we believe investors who can tolerate more short-term pain should sit tight and they will be rewarded. For these investors, worrying about “where the bottom is” only distracts from the longer-term opportunity. The risk in getting defensive now is missing out on the upturn. It’s easy to say, “I’ll get in when the market stabilizes.” The reality is that it is not so easy to know when the market is stabilized. If the market is up 10% in a week, is that the start of a new bull market or a head fake? There is no way to know and most investors who didn’t want to be in the stock market at lower prices will have a very difficult time pulling the trigger to get in at a higher level when many of the headline risks still exist (and they will). The difficulty of the buy-back and our belief in our valuation work (and what it suggests for coming returns) is the reason we don’t raise cash and “wait it out.” But in order to be patient any investor must be able to tolerate the economic and psychological impact of more losses in the near term, should they occur.

What Are The Risks To Our Analysis?

The primary risk is that the economic recovery is very weak or that it falls back into recession. The worst-case scenario could be a debt-induced deflation if households and the corporate sector rebuild balance sheets and don’t spend or invest. As noted above this is a lower probability scenario but it is not out of the question. The stock market is already discounting some of this as a possibility. But if it happens the upside will be more limited in the foreseeable future and there will be more downside.


Jon Houk, CFP®