March 31, 2009

• Stock market valuations are at levels where investors can buy into equity indices and very likely make a lot of money in the next five years.  However, valuations are not at such extremes that there is an “all clear” signal for the next five months. Getting out of our heavy cash positions and back into stocks is going to be more a function of time than of price.
• The stock market can often reveal more about its prevailing strength or weakness by its behavior during a counter trend reaction; the market’s behavior during any upcoming pullback is important.  If selling is not especially intense, the probabilities would favor even more upside potential in the weeks and months ahead and potentially an upward retest of the 200-day moving average (currently 1,000 points on the S&P 500). 
• Officially, we are in recession.  But there are some tentative signs that the economy is trying to stabilize.  There is still a lot of healing to be had, but the brunt of the decline, as experienced in Q4 2008 and Q1 2009, is behind us.

An Update on Valuations

On March 6, 2009 we wrote a white paper titled “Valuations” which largely covered the more traditional price-to-earnings ratio metrics.  More specifically, that particular piece placed emphasis on the ratio of the current price (aka “P”) relative to 12 months of trailing and/or expected earnings (aka “E”).  And that view on that day (especially within the context of an extremely oversold market) – while cautious – was generally positive citing that while the probability that the magnitude of long-term stock market reward is greater than that of long-term stock market risk.  Said in a different (but hopefully less confusing way), we are very bullish on the next five years but we want to spend the next five months being cautious.

Some of the work we will show here will help explain why we remain cautious regarding the stock market in the face of a slowly improving economy and historically attractive stock market valuations.  Our view is that getting back into stocks over the weeks and months to come is more of a function of time than it is a function of price.  And part of the reason we don’t put all of our chips into the stock market at this very instant is because a slightly modified version of the P/E ratio had not reached the all clear signal in so much that it did not get to the extreme levels experienced at the bottom of previous major bear market bottoms.

As we have discussed many times before (including the March 6th, 2009 white paper), without being overly redundant, traditional P/E ratios have flaws.  One way to overcome some of those flaws is to compare the price (P) of the stock market not to just 12 months of earnings (E), but to ten years of earnings – often called the Cyclically Adjusted Price-to-Earnings ratio, or CAPE ratio.

A stock market bottom (no matter how pronounced the bounce up may be) cannot hold if stocks remain too expensive.  And that is why P/E ratios are proper metrics to consider.  By comparing stock prices to the average of the earnings per share produced over the previous ten years we can better control for the effect of the profit cycle, which otherwise would mean that “12-month multiples” tend to be higher when profits were at the low point of the cycle (and, conversely, these 12-month multiples would be lower when profits are high).    So using ten years instead of 12 months gives us a smoother picture of whether or not valuations have reached extremes, while also accounting for the potential flaw of relying on expectations (which are themselves often flawed).

CAPE ratio multiples reached their greatest extremes in 1929, 1965, and 2000 – three market tops that were followed by severe bear markets.  In October 1987, prior to Black Monday, the CAPE ratio peaked at a much lower rate, signaling a decline of lesser magnitude.

Significantly, the CAPE ratio now suggests that stocks are slightly cheaper than their long-term average for the first time since 1991 (and at its lowest since 1986).  This is encouraging, but we remain cautious because stock markets are prone to overshoot and become too cheap after prolonged periods when they have been too expensive.  Thus it would be historically consistent to see stocks fall much lower before finding a bottom, even though they are currently fairly priced.

At 800 points the S&P 500’s CAPE ratio is about 13.90 and that is below its average since 1870 of 16.34 (its average since 1923 is 17; its average since 1990 is 16.25).    As attractive as this makes stocks for the long run, in the past 14 recessions the average trough valuation of the CAPE ratio has been 11 times.  And in the previous economic contractions that lasted about as long as the current one, CAPE ratios were much lower.  The CAPE ratio dropped as low as 6.6 during the 1982 recession; the CAPE ratio dropped to 8.3 at the bottom of the 1973-1974 recession.  So our concern is that while stocks are cheap they could get cheaper.  As such, buying of stocks should be done cautiously. 

The good news?  Although the monster rally from the March 6th, 2009 lows has severely distorted valuations in just a short period of time (a 25% change in prices will do that), at its low of 666 points on the S&P 500, the CAPE ratio was just 11.57.  That is certainly close enough to the aforementioned average trough level of 11.  And thus we have gotten close enough to a stock market bottom for us to gain confidence in beginning to buy equities for growth-oriented investors over the coming weeks and months. 

However, also lending us some caution is that, theoretically, P/E ratios ought to spend as much time below their long-term average as the do above.  This suggests that stocks may not only move sideways for some period of time, but that any quick pop in prices (like those off of the March 6th lows) may be subject to a similar retracement of prices.

Other good news is that the stock market started its multi-year bull market run of 2002-2007 while the CAPE ratio was still above its long-term trend.  As such, lower prices from these levels are certainly not a prerequisite to demark the beginning of a new multi-year bull market.

But the caution lies in the approach of reinvesting into the stock market – not in the act of whether to reinvest or not.  Bear markets usually coincide with periods of recession and their ends usually coincide with similar troughs in valuation.

New Bull Market?

In past bear markets, almost every major rally has sparked a debate asking “is this a new bull market?”.

The stock market rally from the March 6th low has been impressive in terms of how quickly stock indices have climbed by as much as twenty percent.  The S&P 500 jumped 25% in just 15 trading days – its most violent leap since 1938 (the 25% jump from the November 20, 2008 lows in just 30 days was also quite remarkable; and the 15% rally after the Bear Stearns rescue in March 2008 was also quite formidable). 

Clearly, buying interest in stocks (i.e. demand) has improved and buyers have more recently regained control of the equity markets. But as encouraging as it is to see stock prices actually go up for a change, we are actually waiting for the stock market to come back a little bit.  That’s not a forecast or an expectation, but an acknowledgement that it would be helpful to Berkshire Money Management in trying to gauge the sustainability of this recent advance. 

The stock market can often reveal more about its prevailing strength or weakness by its behavior during a counter trend reaction; the market’s behavior during any upcoming pullback is important.  If selling is not especially intense, the probabilities would favor even more upside potential in the weeks and months ahead and potentially an upward retest of the 200-day moving average (currently 1,000 points on the S&P 500). 

The bullish scenario would not only be a narrow and low volume pullback, but also subsequent secondary highs on the major indices accompanied by higher highs for breadth indicators.  We will be watching the tape carefully.  It may not be long before the evidence is sufficient for increasing equity exposure.

Singularly, there are some very positive – and some very negative – stock market indicators.  However, market analysis is rarely simple and no one indicator tells the entire story.  But part of the complicated equation is that we need to see, in aggregate, some improvement (or at least some slowdown in the descent) of the overall economy.

It’s more about time than it is about price

Liam Denning of the Wall Street Journal recently reminded us that “Those afraid of missing the turn (of the stock market) should note an analysis by Richard Bernstein of Bank of America Securities – Merrill Lynch.  Examining 10 prior stock-market troughs, he finds that, on average, keeping your money in Treasuries and only buying into the stock market rally six months after it started earned a higher return that buying in six months prior to the turn.  As ever, it pays to be fashionably late.”

Improving economy 

We hate to be the bearer of good news because we do not wish to come across as Pollyannas.  But there are some tentative signs that the economy is trying to stabilize.  Officially, we are in recession – a deep recession.  But we are keeping an open mind to an earlier than expected recovery.

April marks the 17th month of the recession that officially began in December 2007, making it the longest downturn of the post-Depression era.  This past week, though, has brought some good economic news. 

Consumers held up better than expected in the first quarter.  We are still waiting for final data, but real consumption is still tracking around 1% at an annual rate for the first quarter.  That is a substantial improvement from the 4.3% decline in the fourth quarter of 2008.  Spending will get a lift in the second quarter from tax cuts that will show up in paychecks, which will support spending in services and nondurables.  Last week (March 25th) spending on durables (big ticket items) surprised handsomely to the upside.

Other important improvements are modest inflation (no deflation), consumer sentiment and small business confidence have steadied, and labor and manufacturing markets (while still weak) have also stabilized.  And although still far from normal, funding markets are showing far less stress than three months ago.

There is still a lot of healing to be had.  A turn toward positive growth is not the same as a recovery.  While we may emerge from the recession from a statistical standpoint later this year, many unemployed people will be hard-pressed to tell the difference between a recession and a recovery.  But we have passed the period where every indicator is plummeting.  To be certain, we are not yet at the turning point, but we are getting close to it.

Bottom Line

Clients of Berkshire Money Management, no doubt, have picked up on a different tone than that used over the previous year-and-a-half.  We have been very pessimistic during a period where, in retrospect, it paid to be very, very, very pessimistic.  Given that background we understand that readers of this Quarterly Update for the Economic Outlook for 2009 will be hesitant to believe that the economy and the markets are stabilizing. 

As human beings, we over-extrapolate the recent.  When the times are good, we think that they’ll never go bad.  And when times are bad, we think that they’ll never get good.  It is part of the human-condition; we allow ourselves to be influenced by emotions like fear and greed – all of us. 

But if we step away from the emotion then we can begin to see improvement – if not rays of sunshine then at least light at the end of the tunnel.

It is important to note that this new found “optimism” (I suppose optimism is relative) is not coming from an investment adviser that for the last eighteen months has said such cliché things from the advisor-playbook such as “we’re in it for the long-term” or “stay the course” or other such nonsense.  Berkshire Money Management was very active in selling equity positions and building up cash and CD holdings. 

But we are neither perma-bears nor perma-bulls.  We must acknowledge the economy and we must acknowledge the tape.  It seems that today everyone has a near-religious belief that either the bottom is in or that the stocks are going to, yet again, crash.  We are more agnostic.  We are more neutral, but with clear and open minds. 

It is clear to us that the worst is behind us.  And we are open to the idea that the economy will again lean toward growth sooner (within the next six months) rather than later.