Tuesday, March 3, 2009 4 comments

Market has fully priced in the recession... question is valuation

I believe that the stock market has now fully priced in the recession. Any future markdown of assets, ignoring the irrational panic-selling, is likely related to valuation and not the economy. Let me recap my current stance.

Economic News Irrelevant Now

Economic numbers have been really bad all year long. The following graphic from The Globe & Mail illustrates the 4th quarter GDP numbers for Canada, USA, European Union, and Japan:

(source: Lending rate near zero by Kevin Carmicheal.
The Globe & Mail, March 3, 2009)

The 4th quarter numbers have been terrible, with industrial exporters like Japan hit hard (same with Taiwan and Korea.) America's number was far worse than what I had expected an year ago. I thought there was a chance of America getting away without a real recession (sort of like 2000-2002) but felt the worst case was closer to mild recession of around -3%, which is what Canada posted recently. I was wrong. But it all comes down to the numbers over several quarters. A country posting -3% for a few quarters is obviously worse off than another posting -5% and then subsequently seeing expansion.

Given my belief that the market has priced in the economic gloom, I think there is a strong chance of a massive rally in the stock market (say 20% to 30%.) If we are in real bear market, rallies may be sold since investors will try to get out from their losing positions. From a long term point of view, though, it's still not smooth sailing since it's not clear what is a sustainable valuation.

Valuation Is All That Matters Now

If you are a value investor, I would ignore all macro and just do a lot of work on selecting a few good stocks. If you are macro-oriented, like I am, I would downplay economic news and concentrate on figuring out if valuations are low enough to buy. Of course, when I say ignore economics, you should still pay attention to major events such as military conflicts, trade wars, the collaspe of the EU or one idea I had contemplated, potential implosion of China. Apart from these events, I would just concentrate on valuations from a macro point of view.

I remarked a few months ago that the stock market was still not cheap. The long-term 10-year P/E valuation was nowhere near cheap; neither was the short-term P/E. The market cap to GNP chart cited as a bullish sign by Fortune still wasn't cheap (It's actually a mystery to me how Fortune can say the market was cheap when the current ratio is closer to the peaks in the last 100 years (late 60's; late 20's.))

As I speculated in a post a few days ago on the 10 year rolling returns and bear market cycles, the current bear market, if you assume it started in 2000, has been quite long by historical standards. Yes, we only have a few data points and none of this is statistically significant. Yet, it should give some comfort to bulls to know that we are getting into record-setting territory if the market continues to decline for many more months. I will note, however, that the bull market in the 90's was so massive that one should not be surprised by a nasty bear market (either one that drops a lot quickly or one that goes sideways for years, with huge rallies followed by massive sell-offs.)

The 10 year rolling return also points in the bullish direction. Market may decline more but most of the valuation contraction has likely occurred already. For a 10-year buy-and-hold investor, you are likely to see a positive return that beats all other asset classes. Warren Buffett, in his famous New York Times article late last year, mentioned that buying American stocks will beat bonds. Well, right now, I would extend that view and say that stocks will beat all other asset classes as well.

I am seriously trying to decide if I should invest in special situations, which tend to have fixed limited upside; or whether I should consider buying stocks for the long run. The problem with the latter approach is that your capital will be stuck, if the stock drops after you buy it (to be conservative, I like to assume that stock price will drop after taking a long position and I can't exit for many years without a loss.) In contrast, if one has money allocated to special situations, money will continuously be freed up (assuming an M&A deal doesn't blow up or a liquidation doesn't drag on for years or whatever.)

(You may want to read the few posts tagged as market valuation if you are interested in anything I said before. I'm not trying to boast at all, especially since I lost a fortune on Ambac, but I feel the first post on Graham-Dodd 10 year P/E has foreshadowed everything that has happened. I should have paid more attention to the last sentence I wrote on Auguest 15, 2007. My mistake was that I was expectating a potential recession and/or market correction but I did not anticipate a financial crisis. Needless to say, I never would have invested in Ambac if I had expected a financial crisis (do note that Ambac may have gone bankrupt even without a financial crisis but the financial crisis made it far tougher to survive.))


4 Response to Market has fully priced in the recession... question is valuation

Jae Jun
March 4, 2009 at 1:38 AM

Im just going to stick to my guns and keep buying as prices go down. Im getting killed here holding onto my long positions but am confident that I'll do well if there is a rebound.

March 4, 2009 at 11:15 AM

I think you'll get a rally but the question is what happens in the long run. Will prices fall much lower or will they gradually inch their way up? I think if you are buying undervalued stocks, you'll be fine as long as you are satisfied with the fundamentalsreturns (e.g. if a normalized earnings yield is 10% and you are happy earning a maximum of 10%, you'll be fine).
Where I see risk is with an investor hoping for valuation increase. For instance, if a stock is undervalued but you need the market to price it better (e.g. say p/e is 10 but you expect it to be really worth a p/e 15) then it is risky. I use P/Es but replace it with whatever else (DCF, etc) that one likes using.

capitalist roader
March 5, 2009 at 10:00 AM

i have to agree.ss if you buy based upon value and not price, you can find lots to buy now.s i have been valuing companies on a 5-10 year average earnings basis and assuming very very modest growth and they are still trading below the value i come up with.ss
who knows when the market turns, but if you buy businesses for less than they are worth, you will prosper.s eventually.

March 6, 2009 at 1:40 AM

Pessimism is overwhelming right now.s We have awful economic data.s The economic slowdown is worldwide.s Public debt is crowding out private debt.s Over on Calculated Risk they have a chart that shows this stock market sell-off to be the second worst in a century.
So I figure that a depression is currently priced in at these levels.s We have far exceeded the peak to trough drops of past recessions.
I am not necessarily convinced that we'll see a big bounce though in the next couple years.s Banks will continue to be stretched thin, and capital scarce.s I suspect that commodities will slowly tick higher, and stocks may continue to lose ground in real terms.
Of course, I'm not a macro guy, but it's fun to try to decipher the future.

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