I am embarrassed to tell you that I still haven't finished the second part of my article "Making Sense of an Implosion". I really am not sure what the problem is but I will say that I seem to be acting just like the markets this week. It seems I just can't sit still. Like I'm taking in too much caffeine or sugar; though that is not the case. Perhaps the weekend will provide an opportunity for me to refocus. In the meantime I press onward with some comments on this weeks market activity and a comment on the election.
But let me begin with this email snippet received just this morning...
The bailout, a different perspective: Back in 1990, the US Government seized the Mustang Ranch brothel in Nevada for tax evasion and, as required by law, tried to run it. They failed and it closed. Now we are trusting the economy of our country to a pack of nit-wits who couldn't make money running a whore house and selling booze?
S&P 500 Daily Chart - click to enlarge
The fact is you are bound to see more of these so called bear traps as time goes on and the week's activity offers me a prime opportunity to outline why.
The Fundamentals.
On October 31 the S&P 500 closed at 968.75 with a price-to-earnings (P/E) ratio of 18.86 which is based on earnings of $51.37. "What", as I was asked earlier this week, "is the P/E ratio?" Simply, the P/E ratio reflects the amount that you are paying for each dollar of company earnings. Based on the numbers reported here, each dollar of earnings is costing $18.86.
Another important aspect to this ratio is its indication of how long it would take for the earnings of a company (or index) to equal the share price that you paid. Effectively it would take 18.86 years for the companies in this index to earn the equivalent of the share price you paid today! That "assumes" earnings are at least the same as they are today for those 18+ years. Recent company reports and anecdotal evidence indicates that many companies are entering or are already in a period of lower earnings so that idea is out the window.
From an historical perspective, a bull market (or a sustained rally for that matter) has never started with a P/E above 15. In fact, real bull markets typically start when the P/E is in single digit territory. That alone should give you some cause for restraint when thinking about re-entering the market. We have a way to go before we can believe, with some confidence, that a bottom has set into this market. And that, ladies and gentlemen, is just based on the P/E ratio. I am not going to bore you with the myriad ways I could slice and dice the fundamentals of this market to arrive at a similar conclusion.
The Technicals.
Okay, I know, I've heard it a thousand times before. P/E schmee/eeee...so what?! For you my friend I present a weekly chart of the S&P 500. Voilà...
S&P 500 Five Yr Wkly Chart - click to enlarge
If you read me posts regularly you've seen these charts before. [For you new readers: Welcome. Get use to the charts.] Here you clearly see that the overall trend is down. Friday's close of 930.75 is some 344 points below the 45 week moving average! If you've read my how-to you know that, as an investor, you should never be in an index when it is trading below the 45 week moving average.
Now, if you look close you see that the index dropped some 30 points over the past week. Also worth noting is that you would need a sustained rally of 290 points just to get back in the vicinity of where the market was in August. Look at the rest of the chart. At no point in the last five years has the market recovered 200+ points in a straight line.
So, let me ask you: do you honestly believe that the market can sustain a meaningful rally when you are already paying $18.86 for $1 worth of earnings? When consumer spending is down (the advance GDP report was -0.3% growth and is bound to be revised downward) pointing to declining company earnings? And, when the market is in a clear downtrend? C'mon, don't kid yourself. This is a sucker's bet.
What Should You Do?
If you are out of the markets - as I previously suggested - stay out. If you're in the market, look at the rallies as a great opportunity to recoup your losses and get out. Also, don't lose sight of your goal here. Are you a day-trader? If so, this market churn is a great opportunity to make some coin. Most of us are typically investors meaning that we have a longer time horizon. Obviously we want to buy cheap. Based on current earnings, a P/E of 15 would equate with a closing price of 771 points. Some 160 points below where we are today! This market is far from cheap.
What am I doing? Well, my portfolio is divided. With the money I have allocated to index investing, I'm sitting on the sidelines. Collecting monthly interest. As for my stock account I have not sold anything I own. Largely because I bought bargains to begin with. And, I will be bargain hunting again in December.
There are a few events I would like to see wash out first: portfolio managers that are re-balancing their funds before year end, the rest of the earnings reports for the third quarter and, earnings pre-announcements for the fourth quarter. In fact, here is a great analogy on how I am buying stocks this time around: if you have ever gone shelling on Sanibel Island in Florida, I'm the guy out there at low tide right after the hurricane passes through looking for the sand dollars and angel wings.
The Presidential Election.
It probably comes as no surprise that I am a registered Republican. This is largely because I believe in the ability of individuals and the various states to make better decisions and be better problem solvers than the federal government.
Political affiliations and campaign rhetoric aside, I think that we can agree that we have elected great and not so great people to lead this country. Abraham Lincoln and Dwight Eisenhower (both Republicans) had to contend with racially charged issues that tore at the very fabric of the country. While Lincoln's handling of the Civil War is well documented many of us forget that President Eisenhower had to send the National Guard into Little Rock, Arkansas to ensure the successful (read peaceful) integration of Little Rock Central High School in 1957. From a timeline perspective, the 92 year span from the end of the Civil War to the Supreme Court decision on Brown v. The Board of Education (the precursor to Little Rock) was, at the least, abysmal.
The assassination of Martin Luther King in 1968 was a grim reminder that we still had a long way to go before we could be considered a united people. Yes, even my own experiences in police work made me painfully aware of the strain on race relations in this country. Frankly, I never understood how one human being could act superior to another based on skin color (or anything else for that matter).
It is impossible to anticipate what a Barack Obama presidency will be like largely because it is impossible to predict what challenges he will face. But on November 4, 2008 we took a large step in becoming a more united people. Perhaps we have come to a time when we can discuss issues and find a middle ground. No amount of legislation will prove as powerful as our sense of decency and humanity toward each other.
Please send your questions and comments to Bill Mazzacca
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