Wise men to whom we should listen respectfully (such as George Soros) are saying this is the end of the 60-year post-World War II supercycle, and the secular abyss looms. However, after living through (and surviving) nine panics over the past 45 years, my intuition is that we are close to the end of this one, and that markets around the world are poised for a rally that could be as violent as the decline. It sounds dramatic, but the Dow Jones industrial average could rise a thousand points. Here are the reasons why:
First, stocks around the world are cheap. We employ a variety of valuation models based on earnings, free cash flow, book value, interest rates and inflation. They show that equities are either very cheap (versus interest rates) or moderately undervalued (earnings and book value). All other busts began with stocks at extremely expensive levels.
Second, U.S. equities in particular have already had a big decline. The S&P 500 in nominal terms is more than 20 percent below its high of eight years ago (far more when adjusted for inflation) even though earnings and dividends have risen 30 to 40 percent. The emerging markets as a group are selling at about 12 times earnings despite superior growth and not really being involved in the U.S. credit crisis.
Third, the world is still healthy. The European and Japanese economies are weakening, but not collapsing. The emerging countries now account for 30 percent of world GDP and will grow roughly 5 to 6 percent in real terms this year. The big locomotive, China, will slow to perhaps 10 percent. World GDP growth should be in excess of 3 percent. That’s hardly a disaster.
Fourth, the U.S. economy is in a mid-cycle slowdown or a mild recession at worst. The weak dollar has made America very competitive again, and exports are growing and new plants are being located here. The federal government’s stimulus program will boost activity by late spring, and the worst of the home-building collapse is probably behind us. American companies around the world have paid down debt, have large amounts of liquid assets and are poised to increase capital spending. The biggest American companies, which dominate the market averages, earn almost half their profits abroad, so the weak dollar actually boosts their reported profits in dollars.
Fifth, stock markets are manic-depressives swinging between fear and greed. Investor sentiment today is extremely bearish: fear dominates. We measure sentiment systematically, so this is an assertion, not a guess. This degree of bearishness is consistent with market bottoms. In the past, it has been wrong to be underinvested and selling shares when the bad news is on the front page of The Wall Street Journal, on the cover of BusinessWeek, and is blaring on CNBC.
Finally, the so-called Authorities, the Federal Reserve and the government, have the knowledge and the powerful tools to avert a plunge into the abyss. They have now clearly signaled they will do whatever it takes to revive the economy. Persistent recessions, deflation and long, devastating bear markets as in 1929 and Japan in the 1990s occur when the Authorities don’t “get it.” However, the Authorities’ actions this time probably will result in higher inflation, as they flood the system with liquidity.
A lot of immoral and even evil things have happened in the credit markets, and there are many reasons to be worried. There is a risk of a vicious downward spiral in asset prices—homes, stocks, fixed-income paper. However, I believe the bad news has been discounted in equity prices. It’s important to recognize that the news doesn’t have to be good for stocks to rally. It just has to be less bad than what has already been discounted.
Most market lows trace out double bottoms. In other words, stocks fall steeply, rally sharply, then fade again and retest or even slightly undercut the first bottom. Key markets around the world made lows at about current levels on Jan. 22 and then rallied, only to fall back as the credit crisis deepened. They are currently laboriously testing those January levels. If they hold, it could be a signal that a strong rally is coming.
There is a huge amount of liquidity on the sidelines, and the most aggressive investors, particularly hedge funds, have massive buying power. They cannot afford to miss a sustained rally. Manics can have violent mood swings. Fear can quickly become greed. The upturn could be explosive.
There is an old trader’s saying: “If you think it’s a bottom, it’s not. If you know it’s a bottom, you missed it.” In other words, if you wait until the storm clouds have cleared and markets are healthy again, it will be too late. Admittedly, I’m an optimist—but I’d say buy some blue-chip stocks now.
