Valuations, Bearish Sentiment Point to Important Market Low

As a result of the recent market rout, which came after a full year of steadily weakening prices, global equities and corporate bonds are trading at their cheapest levels in two decades.   Suddenly, risk premiums have returned in a very big way.  Investors are today being paid (generously, if history is a guide) to take risk, but they need to have some basic confidence, a longer-term orientation, and a willingness to tune out the media cacophony and the wild day-to-day fluctuations in market prices.

I have no idea how quickly risk assets will rally, or whether there may be even more weakness in the short term, but valuations and sentiment conditions are at historically attractive levels that have produced outsized multi-year returns for investors.  In short, the risk/reward is favorable enough to suggest that this is as good a time as we have seen in decades to deploy capital in the financial markets.    

 

From this stage, to argue that things are going to get worse is to argue that we are returning to a 1930s-type Great Depression.  For a host of reasons, the probability of that scenario is extremely low.  A much better bet is to side with the resilience and aspirations of the global economy, and the coordinated reflation and stimulus efforts of global governments.  Policymakers are literally "throwing everything but the kitchen sink" at the problems, including direct investments in banks, flooding the system with cash, backstopping commercial paper and money markets, and generally acting as a loan clearinghouse. These measures dramatically reduce the odds of catastrophic economic collapse.

Yes, Wall Street finance is in disarray.  Yes, credit has been fundamentally re-priced.  Yes, lending standards have tightened.  Yes, it will take time for households to repair balance sheets.  Yes, the economy will continue to suffer in the short run.  Yes, investor confidence has been shattered.  However, all of these realities appear to be more than priced into risk assets as a result of the recent meltdown. This bear market has already declined 43% (S&P 500) and taken back 85% of the prior 5-year bull market gains.

In all likelihood, the main risk that investors have to deal with is short-term in nature - more forced selling by hedge funds and mutual funds that must meet margin calls from lenders and redemption requests from investors.  Such forced selling is causing a wide array of assets to be liquidated with no consideration for current value or future earnings. 

 

I can't say that the emotional selling and the forced selling (from margin calls and investor redemptions) won't continue in the short run. But I do believe the worst-case downside is limited to the 2002/2003 bear market lows, which were 780-800 on the S&P 500.  Further, any such weakness would in all likelihood be very temporary; the S&P 500 at a price of 800 would be such an "overshoot" below longer-range fair valuations that value buyers (following the lead of the likes of Warren Buffett and Jeremy Grantham) would quickly step in to pick up assets at bargain prices.

I am hopeful that stocks will not descend to those lower prices and that the market is currently putting in a bottom.  Last week provided a few encouraging signs that the financial markets are becoming a bit less stressed. Commercial paper rates dropped to three-week lows, and the 3-month LIBOR (the interest rate that banks charge each other for short-term funding) ended last week at 4.42%, down from 4.82% the prior week.  This rate is still extremely high given that the Fed Funds rate is 1.5%, but it is a step in the right direction.  We'll know when some basic confidence and stability has been restored when the 1-month T-bill yield rises from its present level of 0.10%. 

In the stock market, what we'd ideally like to see is multiple days (not necessarily in succession) of upside volume swamping downside volume by a magnitude of ten to one, followed by a significant abatement of volatility.   Intraday swings of 5%- 10%, while a hallmark of an important longer-term bottom, are not conducive to investor confidence. 

Comments

[Moses:]

"all of these realities appear to be more than priced into risk assets as a result of the recent meltdown."

"appear to be", lol....

2008 Oct 20 11:21 AM