At worst the tax cuts will validate current market valuations, says Tom Essaye. At best they’l...
Don’t Fear Market Ghosts
05/24/2011 9:00 am EST
Investors are worried that the current market pullback will turn into a full-fledged bear market. Here are 3 things investors should have learned from recent crises.
The stock market is haunted by ghosts of the bear market of 2000 and the financial crisis of 2008. Every time oil tumbles or silver plunges, I can feel the icy fingers of 2008 creep down my spine, and I can read fear in my e-mail.
"Should I sell my shares of Freeport McMoRan Copper & Gold (FCX)?" I was asked this more than once when silver was on its way from $49 to $35.
Understandable question. Shares of the copper and gold miner fell from $57.73 on June 4, 2008 to $12.18 by November 26 of that year. Who wants to go through that again?
- Renren (RENN), the Chinese Facebook, went public at 75 times revenue.
- The initial public offering of LinkedIn (LNKD) soared to more than $120 a share from its $45 offering price, before closing at $94 on its first day of trading.
- Yahoo (YHOO) rocketed 154% on its first day of trading.
All three sound like they could form a group, but of course Yahoo had its day more than ten years ago, during the dot-com bubble. That bubble turned into the tech bubble and both eventually burst, wiping out not only newcomers like WorldCom, but also established names such as Lucent Technologies and Nortel.
When Greece totters on the edge of default, with yields on its ten-year bonds breaking 16.5%, it revives fears of the mortgage-backed asset collapse that took down Bear Stearns and Lehman Brothers—and almost claimed Citigroup (C), American International Group (AIG), and the global financial system too.
Fear Isn't Bad
This remembrance of bears past is a good thing. Fear is as essential to financial markets as hope. Without the latter, nobody would buy anything, and without the former everybody would buy everything.
But investors are supposed to move from blind panic to rational fear as a crisis moves further behind in the rearview mirror. (Although it's wise to remember that "objects in mirror are closer than they appear.")
We're supposed to have learned something from a crisis, something that will make it less likely to occur in the future, but we're not supposed to jump at every noise or lock ourselves in a panic room whenever a car alarm goes off.
So what have we learned, and what do those lessons tell us about the current likelihood of a crisis turning into a market-shaking bear? (The kind of crisis I'm writing about here is quantitatively and qualitatively different from ordinary volatility or the 10% corrections that investors go through regularly—and that we seem to be going through now.)
NEXT: The Lessons|pagebreak|
What We've Learned (I Think), Part One
Extreme overvaluation precedes a crisis—you might say it's a prerequisite.
Caveat to Lesson No. 1: Extreme valuations are sometimes hard to recognize. The overvaluations of the dot-com bubble were clear to all—even if all thought they could make money as the extreme got more extreme. The insane valuations in the mortgage-backed asset bubble weren't as clear—you had to challenge the prevailing risk assessments for these AAA-rated assets in order to see how badly prices were inflated.
Where we are now on the scale of Lesson No. 1: It depends on what market you're looking at. If you're worried about a conventional bubble, I'd say the danger is relatively low.
In emerging markets, for example, their relatively low price/earnings ratios—the trailing 12-month P/E for the iShares MCI Brazil Index (EWZ) was just 11 as of April 30, well below the 15.6 trailing 12-month P/E ratio for the S&P 500—argues that they aren't going to be the locus of the next blow-up.
If you're worried about a bubble in the US stock sectors that have done the best in 2010 and 2011, industrials and materials, their relatively modest P/E ratios should reduce your fears. The S&P materials sector trades at a below-index PE ratio of 15.3, and the industrial sector is at just 17.2.
I say "just" because:
- First, sectors such as telecom (at 18.9) and consumer discretionary (at 17.5) show higher trailing price/earnings ratios.
- Second, the PE ratio for the materials sector is down 13.5% since the end of 2009, and for the industrial sector, it's up just 0.04%.
Worries about dangers in the Eurozone seem more real. Greece is on the road to default—unless the other countries of the European Union decide to throw more money at the problem. It's hard for me to see how Portugal avoids going the same route eventually.
And if default is the end of the road for these countries, then their bonds—even at the recent yield of 16.5% for Greek ten-year bonds—are overvalued, especially since many banks in Europe haven't yet marked all their holdings of these bonds to market prices.
And, of course, right now Europe's financial leaders are hoping that they can hold the line without Spain falling into crisis. I think that Spain will skirt the crisis—but I understand the depth of the worry. If Spain falls into crisis, then all current mechanisms for dealing with the crisis will turn out to be inadequate.
And then, as my caveat says, there are those instances of overvaluation that are hard to recognize in the same way that overvaluation in the mortgage-backed asset market was tough to see. For example, US Treasuries would seem to be overvalued, given the long-term problems in the US budget and with the dollar.
But are they really? The world currently is willing to pay up for the liquidity and security of this market. As long as that lasts, you can make a case that Treasury values are high, but not completely out of line.
China's property market has the earmarks of a bubble, and some Chinese stocks are priced in bubble land, but is China as a whole overvalued by enough to constitute a bubble? Certainly bad loans at Chinese banks and massive off-balance sheet debt in the financial sector are legitimate worries.
But given the Chinese government's track record of successfully burying bad debt (after the Asian currency crisis of 1997, for example), how much bad debt would be enough to rattle the entire economy?
NEXT: Part Two|pagebreak|
What We've Learned (I Think), Part Two
Any bear market or financial crisis needs a trigger of the kind I've just described. But for a correction, or even a market plunge, to turn into a crisis like the Great Recession set off by the collapse of the market-backed securities market, you need a mechanism for leveraging the damage.
In the dot-com/technology bubble, the leverage mechanism was the relationship between share prices and revenue. Share prices had climbed to bubble levels, propelled by investor enthusiasm, which was built at least in part on overly optimistic (and in some cases downright fraudulent) revenue forecasts, which was built on vendor financing. (Amazing wasn't it, that when companies were willing to finance customer purchases, customers were more willing to buy?)
When stock prices started to fall, companies became less willing to take on debt to buy (or to finance purchases), and Wall Street analysts started to take a harder look at those revenue forecasts. That led to revenue and revenue-forecast cuts, which led to more share-price declines, which led to more revenue and revenue-forecast cuts.
What turned a real-estate bubble in the United States, Ireland, the United Kingdom, and Spain into a global financial crisis was the leverage in the mortgage-backed asset market.
Yes, the inflated price of homes and the mortgage industry's willingness to lend to anybody with a pulse were necessary prerequisites for the crisis. But without the bundling of those mortgages into securities that were then rated AAA and sold to everybody from banks to insurance companies to pension funds, the mortgage crisis would have been limited to institutions invested in individual bubble real-estate markets.
Add in more leverage, in the form of derivatives that let financial institutions think they had laid off risk—and could therefore take on more risk—to counterparties that didn't necessarily have the resources to absorb that risk, and you could turn a local real-estate market failure into a global crisis.
I got my call on the mortgage crisis terribly wrong because I didn't appreciate the power of the mechanisms that the financial industry had created in the mortgage-backed asset and derivative markets to leverage a real-estate bubble.
And it's the memory of how wrong I was, and why, that constitutes my biggest worry about the next crisis. I don't see mechanisms that would leverage any of the triggers that I've mentioned above into a global crisis—but that doesn't mean they don't exist.
Where we are now on the scale of Lesson No. 2: I think I understand the leverage in the euro crisis and therefore how far it could spread. Even if Spain descends into crisis, I think the damage would be limited to specific European banks with big holdings of sovereign debt from crisis countries.
I think it would be a challenge for the European Central Bank, the International Monetary Fund, and the national governments of the European Union to support or wind down these banks. But the problem seems to be limited to specific banks in Europe, rather than endangering the financial system of the world.
I can see a mechanism for turning a Chinese bad-debt crisis into a global economic slowdown, but I don't see the leverage that would turn that slowdown into a global crisis. If China's economy slowed as the country dealt with a flood of bad debt, it would slow growth in commodity-producing countries, such as Australia and Brazil, as well as the economies of countries, such as Germany, that export finished goods to China.
But these countries are in much better shape to absorb a decline in growth than the export economies of Asia were in 1997. It's hard to see Brazil, Germany, or Australia needing a rescue led by the Federal Reserve and the International Monetary Fund, as Thailand and Indonesia did in that earlier crisis.
I can't see a mechanism for turning a crisis in the US Treasury market into another global financial crisis—but that doesn't mean there isn't one. The global crisis that started with mortgages reminds me that the financial markets are connected by newly invented financial derivatives and by interlocking risk-management strategies in ways that can produce unanticipated effects.
I don't see a way that a drop in Treasury prices, of the sort that Pimco's Bill Gross anticipates, would result in the drying up of short-term credit across the globe, or a collapse in the balance sheets of the world's banks. But the mortgage-backed asset crisis tells me that the fact that I can't see it doesn't mean it doesn't exist.
Which leads me to…
What We've Learned (I Think), Part Three
The next crisis won't be a replay of either of the last two, just as the mortgage-backed asset crisis wasn't a replay of the dot-com/technology bubble.
I don't mean to scare you by running through the possibilities, or make you start singing "Don't worry, be happy" either.
A turtle that can't stick its legs and head out of its shell won't make it to the next pond. And an investor paralyzed by the last crisis can't take advantage of the next opportunity.
Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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