Dow Stock Market Bottom or Dead Cat Bounce?
Stock-Markets / Stocks Bear Market Mar 09, 2009 - 03:15 AM GMTBy: Andrew_Butter
According to my calculation the DJIA is currently selling for about 40% of its long-term equilibrium value. That doesn't mean that prices won't go down, but I don't think they will go down very much more; for a few reasons, not least that following the 1929 Crash prices bottomed (my calculation) at 39% of long-term equilibrium value.
Early January I predicted 25% down on end 2008, so Friday was significant for me because the markets hovered around that number. If that was the bottom I was right, although I would have been wrong about the timing, I didn't expect this until 2010.
Perhaps I got it completely wrong?
Outside of the chartists there are, as always, two camps. There are some traders who are saying that the market will turn soon, one I respect is Steve Leuthold of the Grizzly Short Fund who made 75% gain shorting over the past year. He came on Bloomberg last week and said that now is not the time to short, i.e. "don't buy my fund". That's a lot more believable as a prediction than one that ends up "do buy my fund". But he's not going long either; or at least that's what he said...(maybe he lied)?
The other camp is looking at P/E ratios, which bottomed at below 7 on three previous occasions in the past 100 years. They point out that P/E now is about 15 which is only slightly shy of its long term average and on top of that, earnings are going down.
If that argument is right the Dow could bottom at 3,000 and the S&P 500 could bottom at 300 or so, less than half where they are today.
It's a compelling argument, but I don't believe it.
Gut feeling...my "Blink Instinct" says, "go with Steve". But none of us has been here before, even Steve, even though it looks like he's been around the block more than a couple of times. So gut feeling might be deceptive, we all rationalize what we want to believe.
My logic, which I trust less than my gut, is as follows:
1: This may sound completely asinine, but P/E as a predictor of price it is dimensionally incorrect. What we are talking about here is a price at which the market turns. "P" divided by "E" is not the same dimension as "P". It's like saying "(one apple + two oranges = three oranges)".
The correct dimension for PRICE (apart from what's on the price-tag today) is either:
(a) Some measure of future earnings, (or dividend, or net free cash flow, take your pick - and that could be a prediction, the company projections, or the last ten years, take your pick on that too), divided by an interest rate, preferably a long one. That's got dimensions "E" divided by interest rates, "I".
(b) And/or some variation of Book (net assets less liabilities), preferably worked out using depreciated replacement cost not mark-to-market (which defeats the whole point). Working that out is tricky, particularly for intangibles like brand value, (and what gets written up as Book, isn't necessarily that number - it's a construct based on tax codes).
Where you are trying to reach is an estimate for where the market would be IF the market was working properly, that's the base line. The assumption is that in periods of uncertainty and fear, (or debt fuelled recklessness), the market does not properly reflect value. Knowing where that point is, at least gives a landmark, like when you go surfing, you pick a spot on the shore to tell you how far you drifted.
2: The basic logic for the P/E argument, as far as I can see, is that the "Black Swan" this time will look just like the ones last time, all three of them in the past 100 Years.
That just does not make any sense to me; it's one thing to base a prediction on a thousand points of data, but THREE points? I thought what that book says is that even with a thousand points there is a 0.1% chance (or something) that you get to go 20 Standard Deviations from the mean (actually a P/E of 7 is "only" 1.4 standard deviations from the 100 year mean). I don't dispute that markets deviate from the mean, what worries me is basing a conclusion on three points of data.
3. Chad Brand pointed out correctly that the times that P/E ratios were low, earnings were through the roof (http://seekingalpha.com/article/124672). Nowadays things are bouncing around so much you don't even really know what earnings are, and the point is not what they are today, it's what they will be.
You still need to reconcile the P&L to the balance sheet, and that's based on what these days?...Mark-to-market! That's great, talk about basing a projection on dependant variables! In my opinion you would be better basing a price on brand value than the junk that comes out accounting profession with an SEC stamp on it these days (and don't forget, it was lousy valuations that got us here in the first place).
4: Run a regression of "E" against "P" for 100 years, and you get garbage, account for interest rates and it gets worse. There is a reason for that (see above).
So, right now, according my "Opinion of Value" based strictly on International Valuation Standards is that the Dow (and the S&P and whatever - they track), is exactly 159% of the PRICE (price is 38% of value).
That's a buy, perhaps not today, and right now my model (which said SELL/SHORT on 17th September 2008 (it got that right)), says STICK...but I say, someday soon.
My model also says that after it goes up, it will come down one more time (not to where it is now), before life begins again (earliest 2011).
Then I could be completely wrong, all I can say is that if the Dow goes down below 6,000 I'm going to give up and go fishing (too old and fat to surf now).
But one thing is sure, some time in the future, and hopefully by then all of the Dumb Asses that brought us this mess are either broke, or in jail, or both; life will resume, and in the end of the day, the markets never lie.
By Andrew Butter
Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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