Three Ways to Justify a Bull Market, and Why They're Wrong

Wall Street always has a logic as to why markets should go up. Here are the reasons that we will hear in the next few months:

a) Stocks are very cheap, they are only trading at xx trailing (currently 12) earnings - which is the lowest it has been in last 25 years. Note however, the stress on trailing rather than forward earnings. When the bull market was on, analysts used forward earnings - because next year's number was forecast  to be higher than this year's. But now, when next year's number is likely lower, analysts are using trailing earnings. The game is to always use the higher E, and come to a low PE.

b) Stocks bottomed at xx trailing earnings (8x, 10x etc) in the last bear market and so if things become really bad, there is only a 20% downside from here. Really. Right now, we are talking of peak trailing earnings on 2007 - not trough trailing earnings. Stocks bottomed out at low multiples of trough trailing earnings.

One of the most insightful comments came from a fellow on CNBC recently. He said that there was one quarter in the 1970's when annualized earnings came in only at $5 for Dow Jones Index. That quarter, the theoretical PE of the index was close to infinite.

c) Stocks always turn up before the economy turns up. Typical bear markets end when recession is xx% (40%, 50% etc) through. Since the recession started in Nov 2007 and will likely last till Dec 2009, we will be there soon. But, excuse me, till 2 months ago, we were debating whether we are in recession or not. So how is it suddenly that recession started last year.

That is not to say that there wont be massive bear market rallies, like the one which has just started. I wouldn't be surprised if we go up 20% from here in the US before the year ends. However, I am not buying the argument of buying en masse before the economy turns, because nobody knows when that will happen. Wasn't 2H08 supposed to be the recovery time?

S&P EPS for next year is around $50-$70, depending on the strategist. Put in an appropriate multiple, and we can come to an index level. Don't forget that the corporate bond spreads are at all time highs, so the discount rate (WACC) for stocks needs to go up and multiples need to come down.

Many analysts are using WACC's that are below the corporate debt yields of the same company - that's wrong - unless the assumption is that spreads are going to narrow.

Comments

[Moon Kil Woong:]

Something's outta WACC haha. Pun. I couldn't help myself. Yes you are right on all points. PE is irrelevant if E is dropping day to day and I doubt if we are midpoint into the recession. Recession midpoints usually have a few quarters of terrible earnings. We haven't yet seen one yet (Q4 will probably be the first really terrible quarter).

And so far I haven't heard of any regulation, any new Glass Stegal act or something to prevent banks from using brokerages and insurance companies as ways to leverage themselves 20x on their book and who knows how many times if you consider derivatives and hidden off book deals. So far 0% of any of the problems have been solved by this administration so I would be apt to say 9,000 is just the beginning of the fall.

2008 Nov 03 05:10 AM

[Steven Hansen:]

confirmation of when we went into recession......

seekingalpha.com/artic...

2008 Nov 03 05:12 AM

[investor88:]

Good article by Guarav lest we get carried away. Does not seem to be a bull market at all. Anyway Guarav is humble enough to allow for the market to rally a huge 20% from here which would then take us to Dow 11k. Maybe a good idea to trade the bear rallies with stop loss/sell stop.

2008 Nov 03 07:20 AM

[hilo:]

we are in a secular bear market, probably for the next 6 years...ivestors should play to this scenerio and protect there money...like you said there will be bear rallies but no bull is running for many more years...
consumer exhaustion, lower copperate profits, deflation and reccession make the augument to a bull market totally in the realm of fantascy and wishful thinking..

2008 Nov 03 10:21 AM

[Jason Rines...:]

Great comments, nothing to add.

2008 Nov 03 12:38 PM