Friday, March 6, 2009

Time to Buy Stocks?

Um, no. While Buttonhood at the Economist cites research claiming "the US market has only been cheaper for 26 months in the last 140 years," conventional measures like Robert Shiller's 10 year cyclically adjusted P/E ratio suggest that stocks still have a ways to fall. Shiller's method uses ten years of earning data to mute the effect of short term earnings swings either up or down in valuing a stock. Applying this method to historical data gives an average stock price of 16X earnings. Today, the S&P 500 just dipped below 12X. So stocks are cheap, right? Not necessarily. Looking at past big bear markets, stocks typically overshoot on the downside and go to 5-8X. By this measure, there is a nontrivial chance stocks could go down 50% from present day value. James Glassman was right all along - if you erase a zero. Dow 3600!

But it gets worse. As Henry Blodget notes, we are exiting a fifteen year period where stocks have been enormously overvalued. At the peak of the dot com bubble, stocks were 45X. This was unprecedented. Even after the tech bubble collapsed, stocks remained elevated by historical standards, at roughly 25X. Considering we just witnessed the greatest speculative boom in US stock market history, it is certainly possible, as Blodget hypothesizes, that we could well have a longer and deeper trough in the markets than there were after past bubbles.

And this brings us to the notion that the Dow is somehow President Obama's "scorecard." Yes, Obama's economic team could have been much clearer with their plans for fixing the financial system. Their vagueness has certainly contributed to the uncertainty in the markets. But the markets declining from their New Year highs in the 9000s has nothing to do with Obama, and everything to do with the fact that there was a bear market sucker's rally that has since ended. We are exiting a credit bubble that overinflated asset prices across the board - these prices must fall. The president can not artificially inflate the Dow, just as he cannot artificially inflate home prices. Too much of the debate surrounding Obama's housing plan was whether this would "fix the housing market" and "stem the decline in home prices." This is nonsense. Home prices were a bubble; they were much higher than the fundamentals of supply and demand would dictate. Now they are falling, as they must. However, the Obama administration is correct in trying to help homeowners avoid foreclosure. That is where the focus should be, first with refinancing and ultimately writing down the principal for underwater borrowers. This will mitigate any overshooting on the downside with home prices, and ease the devastating social blow foreclosures have on families and communities.

For families facing trillions in lost wealth in the stock market and in home values, this is not welcome news. But it is the truth. That paper wealth is gone and is not coming back. We must get back to actually making things, and lay the foundation for real, sustainable growth in the future with investments in energy and infrastructure.

Update: For what it's worth, CNBC had Louise Yamada on today, talking about the possibility of the Dow going to 4000.

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