Last week started out a little on the rough side as the Dow plunged 186 points on Monday. The quick decline caused the indices to break below the bottom end of the little trading range that had developed over the past two and one-half weeks, and although the volume was very light, the bear case seemed to grow exponentially in popularity as the day wore on. And by the time the closing bell rang, the talking heads were almost unanimous in their view that a meaningful correction had begun.

The source of the discontent was three-fold. First, the chorus of negativity was growing quite loud on the back of the concept that the global recovery, which, as the glass-is-half-empty crowd was quick to point out, may or may not be happening, was almost assuredly going to be weaker than expected. Although this wasn’t exactly a new concept, you never know when a particular concept takes hold on Wall Street. So, it appeared that traders’ focus was shifting away from the end of the recession and to the strength of the recovery. Well, for a day or so, anyway.

Next up was the idea that after a gain of nearly 50% on the S&P 500 since March 9th and an eye-popping advance of 58.4% over in four-letterland, the major indices had become overvalued. It seems that everywhere you turned, you could hear about how P/E’s on the S&P were either “fully valued” or had even become overvalued enough to, in some analysts’ opinions, cause a bear market.

Then there was China. As of August 4th, the Shanghai index up something on the order of 90% since the beginning of the year (+90.65% to be exact). Therefore, it wasn’t exactly surprising to see a correction commence when Chinese officials started talking about the idea of increasing capital requirements for banks. So, with the Shanghai Composite pulling back from the highs, we heard all kinds of talks about bubbles and how the Chinese were going to make darn sure that this situation didn’t get out of hand. To which, I’d like to say, “Are you kidding me?”

Nobody Sees a Bubble Coming

While I have no real argument with the idea that the economic recovery is unlikely to be robust (however, we should note that if you’d like to take a TRUE contrarian stance, betting on a decent recovery would be the way to go) the other two arguments being offered up by the bear camp cause my blood pressure to become a bit elevated.

On the topic of trying to protect against a so-called bubble in stock prices – either here or in China – I’d like to remind our friends in fur that the majority of investors/analysts rarely, if ever, see a bubble coming. But nowadays, in light of the fact that we’ve just been through the pain of a true bubble bursting, everybody and their grandmother seems to be seeing bubbles!

Let’s take Japan in 1989 as our first example. To be fair, as the Nikkei was pushing 39,000 in December, 1989, there was some talk that things might be becoming a little overheated in the Land of the Rising Sun. However, the real talk at the time was about the Japanese way of doing business and how the jobs-for-life approach taken in Japan was a better model. At that time, we Americans were VERY concerned about getting our butts kicked on the economic front as the Japanese were busy buying up prestigious real estate such as the Pebble Beach Golf Club and too many of Manhattan’s office buildings to name. But, in the end, nobody did anything about that bubble and the Nikkei still finds itself down some 73% from the high set 20 years ago!

Then there was the Technology Bubble, which pushed the NASDAQ to 5048 in early 2000. I probably don’t need to belabor the point that the internet craze caused analysts to completely lose their investment senses. And I will NEVER forget the string of analysts coming on CNBC to tell us “traditional valuation measures no longer apply, because this is a new era.”

Yes, there was a very small number of investment pro’s such as Warren Buffett and Ned Davis who suggested that what was occurring in tech was pure folly. However, if you are fair in your thinking, you will recall that no one was concerned about a bubble developing. Heck everyone was still laughing about Alan Greenspan’s proclamation that stocks were becoming “irrationally exuberant!” No, the game at that time was about investors “getting theirs” and not about managing risk.

And finally, let’s spend just a moment on the latest bubble involving housing and the monetizing of mortgages (and derivatives thereof). Please raise your hand if you were concerned about the value of your home going up every six months. Please raise your hand if you could define what a mortgage-backed security was in 2007or if you minded getting a little extra boost in the yield of your money market fund. And finally, please raise your hand if you were concerned about the massive expansion of CDO’s in 2007 (yes, Curt, I see your hand, you may sit down now).

Here’s the first point. After being abused by the bears during 2008 and early 2009, analysts are now singing in unison Won’t Get Fooled Again (and btw, watching The Who’s live version is a great way to spend 9 minutes of your Sunday).

This is a classic case of investors fighting the last war. They completely missed the bubble and the ensuing bear market – but they’ll be darned if they’ll miss the next one! So, in short, analysts are looking for bubbles everywhere.

The second point is a gain of 90% does not always a bubble make. Yes, a gain of 90% in seven months certainly gets your attention and anyone investing in China lately has definitely enjoyed the ride. But, before you go shouting “bubble” in a crowded market, you might want to consider the fact that the Shanghai composite had fallen -70% from October 2007 through October 2008. Thus, the much ballyhooed gain of 90% was actually a "bounce" that only recovered about one-half of the big drop. Is this rally an impressive rebound? Yes, absolutely. But given that the Chinese economy is still growing at a rate of about 10% per year, is this a bubble in the true sense of the word? Not a chance!

Understand The Valuation Math!

My next issue with our friends in the bear camp is derived from those suggesting that valuations are becoming a problem in the U.S. stock market on account of the skyrocketing P/E ratio.

I actually have two responses on this front. First, do the people making this accusation actually understand the math involved with the price-to-earnings ratio? And second, have these folks ever seen a recession/recovery cycle before?

To be fair, there is no arguing the fact that a graph of the current P/E on the S&P 500 gets your attention as the line has gone off the chart. But we must also put this calculation into the proper context given the environment and what we’ve just gone through in the economy.

The key point is that during recessions, the “E” in the P/E ratio obviously goes down as companies see a decline in earnings. And this time, there is no arguing the fact that the “E” went down – a lot. Remember, earnings declines of 33% or more when compared to a year ago has pretty much been the norm for the last two reporting seasons. So, when the “E” goes down and then the “P” goes up – as investors buy in anticipation of an improving economy – the P/E ratio will get out of whack.

In sum, playing the P/E game is always a challenging way to assess the valuation of the market. And right now, this is especially true. So, with the P/E not exactly useful at the present time, it is natural to ask what the current status of the valuation issue is. In short, the research I prefer to look at, which normalizes forward-looking earnings on the S&P, suggests that 1200 on the S&P would be considered “fully valued” given the current expectations for earnings.

However (you knew that was coming, didn’t you?), if the economy’s rebound is better than the current “lame” expectations, then this means the “fully valued” level would increase. And on the flipside, if things don’t progress as expected, then that level could fall. So, since the status of the recovery is clearly in question right now, you may want to stay tuned, because this argument is far from over.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Founder TopStockPortfolios.com

Positions in Stocks Mentioned: None

 

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