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Generational Dynamics Web Log for 25-Mar-08
Many investors believe that the subprime crisis worst is over

Web Log - March, 2008

Many investors believe that the subprime crisis worst is over

The reasoning is incredibly shallow.

On Tuesday morning, one of Wall Street's top financial analysts said that he's changed his "bearish" opinion, and now believes that the worst of the subprime crisis is over for the stock market.

Bob Doll, BlackRock Inc. global CIO of equities <font face=Arial size=-2>(Source: CNBC)</font>

Bob Doll, BlackRock Inc. global CIO of equities (Source: CNBC)

Bob Doll, global CIO of equities at investment management firm BlackRock Inc., appeared on CNBC and explained the reasoning. Other pundits said that they agreed with his reasoning, one saying that "there's an 80%-90% chance that stocks have bottomed out, and will start to go up."

Another pundit said, "This is the greatest buying opportunity for stocks we've seen in a long time."

This is like saying, "We've had a week of sunny weather, and so it will be sunny for the next few months." Or, it's like saying, "I've been winning at the roulette wheel for a while, and that means that I'll keep on winning."

I was amazed by how shallow the reasoning was. This is a guy who's known as "the trillion dollar man," and yet he was completely ignorant of the simplest fundamentals. It makes you wonder whether he's simply an out and out liar, saying whatever he has to, so that he won't lose his clients.

CNBC anchor Becky Quick asked him how he felt about stocks now:

"A lot better than I've felt in a while, Becky. No one rings the bell at the bottom, but I think I hear a bell ringing.

Here's the list. Last week, failure of Bear Stearns, opening up of the borrowing window of the Fed to non-bank institutions, Fed cut 75 basis points, easing of capital restrictions for Fannie and Freddie [quasi-governmental mortgage lenders], Bush administration willing to talk about housing relief, largest daily gain of stocks in 5 years, sharp correction in commodity prices, and it was only a four day week."

Doll is echoing something that I've heard frequently in the last few days: "The federal government is fully on board in doing everything possible to fix this problem. They're throwing everything but the kitchen sink at the problem, and will keep on doing so until it gets solved."

This is the principle reason for optimism, but it's based only on things that have happened in the last week! This is the reasoning of people who believe that "history always begins this morning."

Bob Doll continued as follows:

"I think with valuation levels where they are, with sentiment where it is, where policy being aggressive, creative and bold, I'm not sure were going to get a whole lot news coming our way to give us a chance to buy at these sorts of prices."

Now here's where Doll is probably lying. By "valuation levels," he's referring to the price/earnings ratio, and he's saying (by inference) that valuation levels are low, and that therefore investors will be motivated to buy stocks at these prices.

Either this "trillion dollar man" is lying, or else he doesn't know what he's talking about.

There's a price/earnings ratio chart at the bottom of this web site's home page, and it gets updated automatically every Friday. Here's the March 20 version of the chart:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 20-Mar-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 20-Mar-2008. (Source: MarketGauge ® by DataView, LLC)

As you can see from this chart, "valuation levels" have been fairly constant, around 18, since early in 2006. This can't be a coincidence, and it means that most investors are following the same formula, and keeping the price/earnings ratio constant. Surely Doll must know this, so when he implies that valuations are lower, he must be lying.

Why, you may ask (especially if you're new to this web site), are valuation levels constant, if stock prices have been falling so sharply during the last few months? If prices have been falling, then shouldn't price/earnings ratios also be falling?

The answer is that they would, except that corporate earnings have also been falling sharply.

Regular readers of this web site saw what happened with estimates of fourth quarter earnings. On October 1, at the beginning of the quarter, the official estimates were that 4Q earnings would GROW 11.5%. These estimates kept falling, week after week, as shown in the following table:

  Date    4Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct  1:             +11.5%
  Dec  7:              -1.3%
  Dec 14:              -3.8%
  Dec 31:              -6.1%
  Jan  4:              -9.5%
  Jan 11:             -11.3%
  Jan 18:             -19.0%
  Jan 25:             -20.5%
  Feb  1:             -20.7%
  Feb  8:             -20.2%
  Feb 15:             -21.1%
  Feb 22:             -21.0%
  Feb 29:             -25.2%

By the end of February, when almost all ACTUAL 4Q earnings had been reported, earnings had FALLEN 25.2%.

Now we're playing the same game with first quarter earnings.

Here's the summary from Friday from CNBC Earnings Central:

"As of Friday, March 21st:

14 companies in the S&P 500 have reported earnings for Q1, 85.71% have beaten estimates, 7.14% were in-line, and 7.14% have missed. (Data provided by Reuters Estimates)

The blended earnings growth rate for the S&P 500 in first-quarter 2008, combining actual numbers for companies that have reported, and estimates for companies yet to report, stands at -7.9%.

On January 1st, the estimated growth rate for Q1 was 5.7%. (Data provided by Thomson Financial)"

So now we can update our table of first quarter earnings estimates:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%

March 21 in this table corresponds (roughly) to December 21 in the previous quarter, and so we're on pretty much the same path in the first quarter as we were in the fourth quarter.

Apparently investors are very well aware of this, because they've been keeping price/earnings ratios steady at 18. How could Doll possibly not know this?

Next, Doll addressed the question of asset writedowns. Regular readers know that Citibank, Merrill Lynch, and many other banks have lost tens of billions of dollars, after being forced to "write down" the value of CDOs and other mortgage-backed assets in their portfolios.

"That's why we're down the amount that we were. As you've heard me say before, markets hate uncertainty. And when we have no clue what the number is in terms of the writeoffs, that's when markets get the shivers. When we start to zero in on a number, even if it's a big number, that certainty is preferred to the uncertainty, and I think we're starting to get there. We're not there yet, but we're a lot farther along. ...

There's a light at the end of the tunnel, meaning that we're beginning to get our arms around the magnitude of the problem. Six months ago, three months ago, it was a big black hole. No one had any clue how big the writeoffs were going to be. Now we're beginning to get some handle, but ... a lot of it is still to be written off."

So there you have it. Based on the events of the last week, ignoring all the trends that have been established since August and earlier, all problems are solved, and now the bubble can start growing again. It is truly astonishing to me.

For six years, I've been saying, based on fundamentals, that the stock market is overpriced by a factor of almost 250%, and that we're entering a new 1930s style Great Depression. Those fundamentals have not changed in the last week, or in the last six years.

To repeat what I've said before, if you go back through history, there are many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash.

These are called "generational crashes" because they occur every 70-80 years, just as the generation of people who lived through the last one have all disappeared, and the younger generations have resumed the same dangerous credit securitization practices that led to the previous generational crash. After each of these generational crashes, the survivors impose new rules or laws to make sure that it never happens again. As soon as those survivors are dead, the new generations ignore the rules, thinking that they're just for "old people," and a new generational crash occurs.

We're now overdue for the next generational crash, and it might occur tomorrow, next week, next month, or next year.

In case you've forgotten, here's the historical graph of price/earnings ratios:

S&P 500 Price/Earnings Ratio (P/E1) 1871 to August 2007

S&P 500 Price/Earnings Ratio (P/E1) 1871 to August 2007

Once again, this is NOT rocket science. You can just look at this graph and see that we're close to the edge of a huge cliff that will bring P/E ratios down to the 5-7 range over a three year period, which will bring the stock market down to the Dow 4000 range or below.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (25-Mar-08) Permanent Link
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Generational Dynamics Web Log for 25-Mar-08 Many investors believe that the subprime crisis worst is over

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Generational Dynamics Web Log for 25-Mar-08
Many investors believe that the subprime crisis worst is over