Thursday, October 16, 2008

Irrational Pessimism

The U.S. equity markets are in full scale melt down mode.

Either that momentum stops here, or the U.S. pension system will be the next big bailout (even if it does stop here, that may happen).  G.M. and Ford, the UAW, CREF, etc... all have assumed 9% compounded growth out into forever, yet the equity market's have had a negative return for over 10 years, bonds have had total return over 5% during that time, Real Estate likely has, but certainly not at the moment.  This is scary stuff.

On the other hand, Stocks have been beaten down to the point where dividends actually MATTER.  This has not happened in several decades.  Companies as diverse as Pfizer (7%+), British Petroleum (7%), and G.E. (6.4%) sport dividend yields as much as 50% more than the 10 year Treasury.  Think about it: At a 7% dividend, your investment will increase over 20% in 3 years and double in 10 without benefit of capital appreciation (provided they don't CUT the dividend).  That ain't gonna happen in a checking account.

If you have been reading my stuff for a while, you know that I have been very concerned that the market's were not pricing the housing, banking, and energy issues into stock prices. Markets are discounting mechanisms.  They take in the available information and are "supposed" to reflect everything that is known about the future in the current price environment.  But the element of human emotion brings us to moments of "Irrational Pessimism" and "Irrational Exuberance".  At the moment, I cannot find any evidence that people are not at their MOST pessimistic.  Of the 5 major investment banks, 1 is bankrupt, 2 were acquired, and the remaining 2 had to convert to commercial bank status.  Hedge funds have unwound their positions (just look at the Japanese Yen... seems to me the "carry trade" has been closed).  I feel differently at Dow 8500 than Dow 14,000.

Even using a depressed earnings forecast, the S & P 500 is trading at roughly 13 - 14 times earnings.  The book value (remember that one) for the U.S. Equity market is $5 Trillion.  The total market cap is less than $10 Trillion.  We are trading at 2X book currently.  In 1999 the U.S. was trading at 5X book.

Could things get worse?  They could, but my bet is we are a great deal closer to a bottom in equities than a top.  And if they do get worse?  That would mean a crippling recession takes place, with implications for the value of the currency and sovereign debt.  The banking system MUST function or we might as well shut out the lights.  Again, my bet is that the banking system WILL function.

It is important to keep in mind that EVERYTHING is NOMINAL.  You can't invest, spend, hold, or earn REAL dollars.  The value of the $, relative to the things it can buy, is not static.  It changes.  The MASSIVE amount of increased money supply MUST be considered.  I cannot foresee an outcome that is not extremely affected by this. 

The energy supply crunch that looms before us has serious implications.  These cannot be underestimated.  But with the right leadership much of this can be overcome.  After all, does driving around in circles really benefit GDP? (Some would argue that it does, as it contributes to impulse retail buying.  But do we need more consumer behavior, or more PRODUCTION?)  A massive build out in electric rail, wind, solar, nuclear, hydro, etc... would keep us pretty busy for the next 20 years or so, and if you look at the Natural Gas production numbers, it would seem that this has real potential to get us over the hump.

So, no, the world is not coming to an end.  That does not mean that if one does stupid things: Over spends, over borrows, does not save, have no contingency plans, etc... that YOUR world might not come to an end.  Ever hear the saying "the harder I work the luckier I get"? The last 30 years have been an incredibly easy time to be lucky with out the "work" part.  That is coming to a halt.

Kuntsler's "Long Emergency", or my "Age of Personal Responsibility", or Mish's "The Future is Frugality", pretty much sum up our individual views of a post petroleum future.  Opportunities abound, as do risks.  Those that interpret their environment correctly will enjoy a better standard of living than those that do not.

Good Luck!

Mentatt (at) yahoo (d0t) com




4 comments:

bureaucrat said...

All of the alternative vehicle fuels have significant problems, including electricity. and for that reason, we are stuck with gasoline & diesel. Once the oil peaks, and all the wasted oil has been squeezed from the system (look how much effort it took to squeeze out the piddling 5% we managed so for), companies will have NO problem cutting their dividends (the banks had little problem), and the stock prices will fall. What's the definition of a sucker's rally? :)

A Quaker in a Strange Land said...

You are not taking my NOMINAL argument into consideration. Further, while GM and F might go under, General Solar or Ford Electric Motor might take their place.

There will be a market for debt and equity. If there isn't, no financial asset will have any value, including cash. Also, in the absence of a financial market, we will not be able to aggregate capital, so their will be no large company payroll to tax. And we all know what happens then...

My bet is, we are close to a nominal bottom. Money is coming out of the Gold and debt market; so where is it going?

On the other hand, if you disagree you can make alot of money, if you are right by, shorting the market.

bureaucrat said...

I'm an old fashioned-investor. I have no idea how to short the market. I'll keep my Treasuries for now, thank you. :) Mish is mega-bearish today, saying that OPEC production cuts won't work, and industrial output is badly faltering. There isn't going to be a bottom for some time. Solar? Jeez, Jeffers, you jumping on the bubble bandwagon? :) All this oil, silicon and money invested in solar panels, replacing less than 1% of the U.S. electricity so far. What a waste.

Anonymous said...

Not sure if you know this but the recent bailout bill includes a uncapped 30% tax credit for solar investment. Commercial and Residential.