The stock market is not always rational! Although we do believe that markets move before the fundamentals come into play most of the time, there are other times when markets are just not rational.
The stock market at the end of the financial mania was not discounting the future with NASDAQ trading at 245 times earnings and the S&P 500 trading at 3 times normal valuations. Along with usually discounting the future, we believe that markets also act to entice the largest amount of investors to buy and sell at the wrong time. When markets are extremely overpriced and bump up into resistance a number of times they will usually break through the resistance in order to trap more investors into going long the market. It also works the same way when too many investors are concerned that they have missed the beginning of a new bull market. Markets will move far enough to get these same investors who are champing at the bit to participate in the new bull market. We believe this is happening presently.
The deflationary bear market we have been talking about for some time seems to us to be right on track as far as the latest economic releases. Earlier this week, the latest figures on the trade deficit were the second worst in history. Yesterday retail sales unexpectedly fell 0.1%, and the decline was 0.9% ex-auto sales. This was the largest decline in non-auto retail sales since September 2001. Most economists were also surprised that the import prices dropped by 2.7% led by falling oil prices.
Today the economic releases were more surprising to the pundits. The PPI declined 1.9% in April and 0.9% ex food and energy. Industrial production experienced a slightly larger than expected decline of 0.5% in April. This marks two consecutive months of large declines, marked with widespread weakness in nearly all of the major market segments. Capacity utilization declined to 74.4% down 0.4%. This means that over one quarter of U.S. factories are idle. The initial unemployment claims were over 400,000 for 13 weeks in a row even though they declined by 13,000 this week. A string this long of unemployment claims over 400,000 is usually associated with a recession.
Keep in mind, that we don’t think the recession of 2001 ever ended. The Philly Fed business outlook survey was –4.8% and worse than the consensus estimate. Intel today was cautious about the current economy, confirming a slew of recent announcements from leading technology companies that IT spending was not picking up. In addition, leading retailers such as Target and Kohls are reporting disappointing sales, while retailers across the board are reportedly stuck with heavy inventories of a wide variety of merchandise.
None of these economic releases surprised us, but the market has been able to take this news in stride as it sucks in all the investors and traders that are scared to death that they will miss the next roaring bull market. They don’t seem to understand that it is just about impossible for this market to bottom at the current valuation levels.
After the bubble we experienced in the late 1990’s we expect this market to eventually make a significant bottom as it did in 1932, 1949, 1974, and 1982. All of these bottoms were at valuations of under 10 times earnings and all but one at dividend yields of over 6%. The P/E is presently over 30 times earnings and the dividend yield is under 2%. If this market were able to make a significant bottom from these levels it would not only be unprecedented, but unprecedented by a wide margin..
The numbers we are using for the P/E are “reported earnings” and we expect to be published in this weekend’s edition of Barron’s in “Other Voices” which will explain why we are using “reported earnings” rather than the other earnings numbers used by most of Wall Street.
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