Wednesday, October 15, 2008

Round 3 of a Heavyweight Fight

Every so often, when the market hits an air pocket, analysts trot out the Nikkei Index of japanese stocks and overlay it on the S&P 500. The point being that the japanese succeeded in turning a market bubble into a two decade zombie market. The reluctance of Japanese banks to write down inflated real estate assets after the 1990 collapse resulted in both a market and an economy that has alternatively sputtered and failed to regain its footing for the better part of two decades. The failure of Japanese policymakers to deal with the banking problems quickly and effectively created a dead man walking market.

Whether we have avoided the same fate is unclear, but thus far the signs are not good. I am in fact confident we will not have the "L" recession of Japan, but rather a protracted "U". Innovative, aggressive and politically unpopular solutions will be needed. Hopefully in times of extrordinary need, extrordinary people will raise to the occasion.

Several items give me serious pause. The entanglement of the economy and the credit crisis is masking the issues. It is great that the federal government gathered the banking powers that be into a room and acted like it was making fois gras by stuffing money down the throats of the John Mack and others. But stuffing a goose with grain doesn't make instant pate'.

We are clearly entering a significant recession. Today's release of the Empire State Manufacturing Survey shows clearly that more difficult times are ahead. All indicators were negative and the general business condition index dropped to a record low. The allure of thinking that unfreezing credit will avert a recession has been too strong perhaps. Phrases like, "America is on sale," and "buying opportunity of a generation," have been ringing across the airwaves. I doubt it.

The current earnings estimates for companies are already beginning to be lowered. From the current S&P 500 earnings estimate for 2008 is $77.81. As the most recent quarterly earnings come in we are seeing a significant number of companies surpassing expectations, but the same companies voiceing concern that they will be able to meet year end consensus. In other words, the fourth quarter looks like a serious drop.

The current estimate of analysts puts the S&P earnings at $104.16. On the cusp of a recession and estimates of earnings growth in 2009 of 34.2%? I take that with a grain of salt.

Clearly the financial sector will do better next year. The comparisons with bankruptcy should be pretty easy to surpass. But every other sector shows substantial growth as well. My estimate, which I believe to be hopefully conservative is $68. The historic mean P/E for the broad group is 11. In severe recessions it has troughed as low as 7.

At 11 times $68 the S&P would reach 748. At 7x, 476 we would return to the level of the mid 1990's. It sounds preposterous, but the Maestro Greenspan oversaw three successive bubbles as a result of easy monetary policy. It is not impossible the we could see the unwinding of all three. We already reached 844 for the index which is within 12% of a very reasonable long term investment level. Emotionally, the exhaustion of the past 2 weeks has created a pause. Much of the panic is out of the market but there is still plenty of opportunity for "disappointment", when expected bounces fizzle out.

The first round was the subprime mortgage crisis which emerged in all its glory a year ago. It would appear we have an understanding of the issue now, although no adequate solution has yet been provided.

The second round was the resulting credit crisis as the banking system froze and institutions stopped lending to each other. The lubricant of the capitalist system stopped flowing. The injection of capital into the banks and government guarantees of debts on new transactions should allay these fears substantially. I am not confident the capital is sufficient, but the decision was the first right one I believe.

Round three is the recession which was going to arrive in any case, but has been given a massive dose of testosterone by the credit smack down. The prospect of an average recession has receded and one of greater depth and duration looms. Unfortunately the usual remedies for an economic slowdown, i.e. interest rate policy is already exhausted. There are no bullets in that gun.

The next president will have to take a deep breath, show leadership the likes we have not seen in a generation and call upon us to decide who exactly we are as a nation.

John Barnyak