Saturday, October 11, 2008 2 comments

Time To Invest

I just ran across a good article by The New York Times discussing the current investing climate. It's a good time to invest according to superinvestors such as Ken Heebner and Martin Whitman, among others. Both of them are down around 40% for the year. Whitman's declines aren't a surprise but it's amazing that Heebner, who was up something like 20% in the middle of the year (or something like that) end up with massive losses within a few months. Talk about a commodity collapse.

The best thing about the article is the interactive charts (click one of the left sidebar links,) which plots the current decline against the big ones from the 1930's, among others. It's hard for me to imagine that the current decline is among the worst of all time. Maybe it's because I have done very little all year and the huge decline in Ambac is not surprising. I suppose it is more shocking to see G.E or Citigroup or some "solid" name drop 50%.

Anyway, there is a potential pitfall in the analysis used the article. The article talks about valuations and mentions that on a P/E basis, stocks look somewhat cheap. However, this can be misleading. There are two bearish and one bullish notes to be made about the P/E ratio.

On the bullish side, the P/E ratio is better than it seems because financials reported abnormally low earnings. Even with the unfolding credit crisis, financial earnings over the next few years will be far better than what they were in the last year and a half. I also expect some of the marked to market asset values to reverse so there may actually be some write-ups in the future.

On the negative side, the P/E ratio is worse than it seems because (i) corporate earnings are likely at a high and will drop as the economy slows, and (ii) the P/E ratio is pulled down by the cyclicals (cyclicals have low P/Es at the peak.) Cyclicals--at least the energy and materials cyclicals--were in a bear market in the 80's and 90's whereas they have been in a bull market for the last decade. So they never had the super-low P/Es we are seeing now, and hence didn't "pull down" the overall P/E ratio in the 80's and 90's. (If you think commodities are in a bull market and will bounce back up then this second point isn't so important. That is, the P/Es will stay low for the forseeable future.)


2 Response to Time To Invest

October 12, 2008 at 11:33 AM

I appreciate your enthusiasm but Citi and GE are among the most levered companies out there. A lot the distrust in the financial market is due to Citi being essentially worth nil under a VIE consolidation (which they successfully lobbied to have delayed).

The US is bankrupt and the eventual acceptance of mortgage cram-downs will devastate the financial sector.

I expect USD and Tsy to fall and gold to rise. I also fear a market-unfriendly turn to the left in the US for a generation.

October 12, 2008 at 3:06 PM

SC: "I appreciate your enthusiasm but Citi and GE are among the most levered companies out there. "

Yeah... but how many would have thought that such a company would collapse? The leverage and other issues are nothing new. Everyone knew that before. That's one of the amazing things about this crisis. When Enron collapsed, it was a surprise to many because it involved fraud. When accountants make up stuff it's hard to catch those issues. But the current situation is, in some sense, to be expected. I'm not saying I would go out there and investing in any of these companies; I'm just saying that it is hard to imagine how blue-chip--in the case of G.E, AAA-rated--have collapsed.

"The US is bankrupt and the eventual acceptance of mortgage cram-downs will devastate the financial sector. "

I concur somewhat with that view. That's kind of what is unfolding right now. Goldman Sachs isn't collapsing because of bad mortgages (it has practically no exposure to subprime residential, although it does have some questionable assets.) It's being re-priced for a different future, with lower leverage in the future. The financial sector is going to shrink, just like how the technology sector went through a horrible period after the tech bust.

However, my feeling is that the situation may not be as bad as feared because the economy is still holding up. I don't think USA is quite bankrupt yet. In what can only be described as an amazing outcome (I would say this is one of the benefits of open and free markets), USA managed to unload a lot of the problems on the rest of the world. For instance, most of the toxic CDOs are actually held by European banks. Many private investors all over the world also will take the losses. This will cushion the blow to the country. If this was like the 80's (S&L) and US banks were the only ones exposed, I think the whole financial sector would be on the verge of collapse. But since the losses are spread out across the world, the downside does not rest solely with the US institutions or the banks.

I think a bear call on US$ is a tough call here. The conventional wisdom would be to expect a plunge in the US$. But the US$--also the Yen--has been one of the big underperformers over the last 10 years, it's not clear if the US$ is overvalued. The US$ is not going to decline simply because bad things are happening. It will mainly decline if it is less attractive than the rest. I still think there will be capital flight in the US$ until the situation improves. So somewhat paradoxically, I actually think the US$ will start declining when the situation improves and the rest of the world starts becoming more attractive.

Treasuries are in a big bubble but if deflationary forces persist, I don't seem them declining. Long term, I would agree with you that US treasuries are the last place you want to be.

As for gold, I think it will only rally if USA starts printing money. So far no sign of inflation or money printing of any sort, so gold is an iffy bet here. A lot of people bullish on gold expect money to be printed so it depends on if that actually happens.

Gold had very high correlation with the broad markets over the last few years. This is rare and it basically means that it wasn't behaving as an an anti-market hedge. This is why it is not doing so well while everything is fallin apart. You would think that gold would be hitting all time highs given the bailouts, collapse in stocks, and so forth, but nope. It's actually weak. It didn't collapse to the same degree as stocks but bonds would have beat it this year.

"I also fear a market-unfriendly turn to the left in the US for a generation."

I agree. I'm left-leaning so I don't mind. It'll likely be somewhat negative for markets though. I don't think the shift to the left is going to occur just in the US but throughout the world. The US government is going to be totally dominated by The Democrats (presidency, senate and house will likely be a Democrat-majority, although anything can happen.)

Unfettered capitalism that was popular over the last 10 or 15 years is going to be curtailed. Everything is going to be end up being regulated, perhaps a bit too much.

I also think taxes will go up (partly to pay for all the bailouts and other schemes being undertaken now.)

The real question for someone left-leaning like me is what wing of the left gains strength. People like me are in favour of free trade and free markets, but some wings on the left aren't. I just hope that governments don't do something stupid like passing tariffs (against China and others) or imposing price controls, or stuff like that.

Anyway, we may be witnessing a monumental shift, not just in politics but societal attitudes. As for investing, I think it's safe to assume that future returns on capital will likely be closer to 8% than to the 10% of the past.

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