Sucker's Rally: Stop Calling the Bottom

Co-written by Patrick Kirts

Again and again, the cacophony of bottom-callers serves to lure the overly optimistic and the just plain ignorant onto the rocks of a sucker's rally with their siren song. This is not to say that serious money cannot be made trading in this volatile environment; it can, and it is. We at Portfolio have never traded so much, but we're riding the waves of folly, selling into these rallies, and picking up the pieces again when the waves break. This is evidently not what most people are doing, or there wouldn't be sucker rallies.

Vikas Bajaj's March 14th New York Times article 'Has the Economy Hit Bottom Yet?' provides us with three data sets that help illustrate the essential dynamic at play here. First, he shows us that the S&P 500 average P/E, which was approximately 12 on March 3rd, has finally fallen below the 120-year average of 16.37. Great news, right? Well, in 1932 the lowest P/E was 5.6, after dropping from the 1929 high of 32.6, not reached again until the late-90s dot-com boom, when it reached 44.2 at its height, and in 1982 it got as low as 7. So, 5.6 and 7 are the retraced P/E’s, all we did last week is retrace price. Second, he shows us that housing prices are still expensive when compared to the past 120-years; they're still more expensive, in inflation-adjusted dollars, than the boom years of the 70s and 80s. Third, in the past 80 years, Americans have spent an average of 93 cents of every dollar they've earned; or, they've saved 7%. We're still only saving about one or two cents of every dollar, but the rate is starting to improve. Back in the early 1930’s we actually went above 100% of savings. So, the idea that American’s don’t save is not new and has been worse in the past.

What general picture can we take from these disparate facts? It's true that only the first directly concerns the market, and taken alone, one might think that a twelve P/E could be the bottom. The other two facts should sober us up. We are still propping up housing prices; they need to decline to an affordable level before the market can recover, and until that happens, losses will continue to pile up, driving the market lower. Furthermore, even when they fall, Americans must return to a decent level of saving in order to buy them. Neither of these have happened, nor are they right around the corner. We are also being warned that the next asset bubble to pop is securitized credit card debt. Does anyone in their right mind think the banks will handle this any better than they did the mortgage bubble? And what happens to the economy when this source of consumer spending is drastically cut back? More financial destruction waits in the wings.

In his 1954 book The Great Crash, John Kenneth Galbraith formulated the 'principle of maximum ruin': accustomed to quick recoveries after prior stock market panics, investors rushed in after each drop, confident that the bottom had been reached. Wealth was destroyed in waves from 1929 until 1932. The largest credit bubble in history has just burst, and the market is only very gradually accepting that fact--the principle of maximum ruin, not seen since the early 30s, has returned in a major way.

The market will recover when confidence is restored. Ben Bernanke and the rest of the central bankers around the world seem to think that confidence is just something that can be re-injected into a market. True confidence can be returned only by an improvement in actual economic fundamentals--but every manipulation--and 'quantitative easing' is a HUGE manipulation--further degrades these fundamentals, even though it fools plenty of people back into being bulls. As Jim Rogers recently said on Bloomberg: 'I am suggesting to you that people should be prepared for inflation, because it is coming back, unless something is so different this time, but you know, it's never different this time, it's always going to lead to inflation down the road.' Whether or not we agree with Rogers' prognosis, his sentiment is 100% correct: there is no such thing as a free lunch, but G-men will never abandon the idea.

No one ever successfully calls the bottom, and if you think that you have, you must think it's definitely different this time.

Disclosure: Author holds positions in QID, SDS

Comments

[Dave Wrixon:]

I wish people would stop talking PE ratios. Unless you have some clue as to what is going to happen to company earnings over the next three years, these are pretty meaningless.

Mar 22 03:20 AM

[AussieAviat...:]

Cancer ridden assets need to be painfully written off and not put in a jar whilst relying on what they were worth. You can only give the patient so much morphine before you start killing him with "hyper" inflation. It very well could be a case of damed if they do and damed if they don't. As the writer suggests "There are no free lunches" - hence "you get nothing for nothing" - specifically, how can the consequences of an apparent "$100 trillion" owed by individuals be expected to disappear into thin air over night ?
blog.beliefnet.com/cru...

You know what they say about "nature" and the course of a river.

Ive made good money the past week and gotten out on the 19th. I don't think its ethical to short sell, so ill set my alarm for around Aug/Sept.

Mar 22 04:04 AM

[AussieAviat...:]

RE lat post - My mistake sorry - That should read : I think its UNETHICAL to short sell. :)

Mar 22 04:16 AM

[zermux:]

I like buying low and selling high. I equallly like selling high and buying low. Both are ethical, profitable and essentailly the same.

When you think stocks are going down - go short, when you think they are going up - go long, when you are in doubt - get out.

Mar 22 05:57 AM

[investor88:]

Lee Munson has written some good research here. pe ratio still double trough in 1930s and 1980s of 6 to 8x. Some people say fair value of sp500 is 900, good luck! At 6x per, sp500 may be 400 instead.

Mar 22 09:18 AM

[Asbytec:]

If P/E ratios fall by much more there will be another run on derivatives, probably hedged in AIG, that will make the mortgage crisis look like Christmas.

Mar 22 10:29 AM

[Old Trader:]

Made in W. Germany,

It looks you're trying to wrest away the title of "Dr. Doom" from Rhoubini (and here I thought "West" Germany had gone kaput, since the reunification).

Mar 22 08:44 PM

[cameroni:]

Interesting article,

And I am mostly in agreement with you Lee. The bottom has not been reached by a long shot despite some good noble attempts to re-flate the economy. Some very difficult days lie ahead. The bulls cannot snap out of their pattern of belief in a continually rising market. Nor the fear that they may have missed the market bottom and a lot of profits. They have not yet accepted that the big trend is down and some painful adjustments lie ahead. Hope lies eternal. This is bear season though and the biggest money of the century is all in shorts.

We are due to go through a major structural change in North America in the coming months and years and there will be a lot of broken dreams along this road. Inflation is only one of the threats we face along this path. There is another though that is frankly a much greater danger to the average debtor and home-owner than any other issue to date. It will be personal. It will affect every debtor in America. And it will devastate the survivors of this current asset destruction phase. That looming threat is high interest rates and the trend has already begun. And if you doubt that, then just ask yourself this..."If historical interest rates are at a bottom right now, then where do they have to go but up?"

But that of course is not a rationalization for higher interest rates. Higher rates are a function of the market, the global economy, demand for capital and risk. And contrary to popular belief the government is not in control of these rates. They will be set by market forces outside our borders.

Inflation meanwhile is almost certainly in the cards now and this point was made lucidly clear with the recent debt monetization. The money presses will roll and all attempts will be made to inflate our way out of the mess we are in. Inflation (possibly hyperinflation) as an alternative to a devastating deflationary depression seems OK on the surface but it will actually lead to more wealth destruction than any depression could have achieved. Sometimes it is better to fight the devil you know than the one you don't. So watch closely because the "interest rate" genie will soon be out of the bottle. And that monster will bring a whole new round of business failures and bankruptcies
that will make the current difficult situation look quite tame.

And how damaging will it be? You don't need to look beyond the early 1980's to understand how double digit interest rates damaged the economy and stifled business investment. This is not to mention how home prices were very negatively affected and real fear ruled the markets. But housing prices are already being crushed you will answer. It can't get worse. Or can it?

Sorry. It will get worse. A lot worse too. The housing bubble has burst and market balance will not be restored until it has completely deflated.

Consider that for most people, the interest paid on their mortgage is the largest part of each monthly payment. Principle payments each month are relatively small. If you double interest rates then you effectively double monthly payments. But what if they treble or quadruple. How many home-owners currently underwater on their mortgages will survive even a doubling of their current monthly payments.?

That is the future though and there is not enough bailout money in the global treasury to backstop this disaster. This freight train cannot be derailed. And I sincerely wish I could say that I was making this all up. But I lived through the high-inflation and high-interest rate days in the early 1980's. They were brutal and devastating but this is really much worse because this time we will (economically speaking) be entering into the same situation in a more financially weakened state.

How can you protect yourself?

You should consider that we currently have some of the lowest interest rates in history. You should, if you have a mortgage, think of taking a long term view of the risks ahead. Would you take a one year term-mortgage at 6% in this environment if you knew that on renewal you were going to be faced with 12% at this time next year?

Think about it.

Even if you keep your job and remain solvent, an interest rate spike that doubles your monthly payments could still wipe you out and force you into bankruptcy. And you will lose your home too.

This is a real risk that all debtors need to consider seriously when renewing lines of credit, mortgages and other long-term debt.

I would be happy to hear comments from anyone on this topic because it is simply not being discussed anywhere at the moment and yet it is one of the biggest risks we have going forward.

Cameron

Mar 23 12:01 AM

[Lee Eugene ...:]

Thanks for your thoughts, Cameron. A scary prognosis, and one that I will continue to be thinking about.


On Mar 23 12:01 AM cameroni wrote:

> Interesting article,
>
> And I am mostly in agreement with you Lee. The bottom has not been
> reached by a long shot despite some good noble attempts to re-flate
> the economy. Some very difficult days lie ahead. The bulls cannot
> snap out of their pattern of belief in a continually rising market.
> Nor the fear that they may have missed the market bottom and a lot
> of profits. They have not yet accepted that the big trend is down
> and some painful adjustments lie ahead. Hope lies eternal. This is
> bear season though and the biggest money of the century is all in
> shorts.
>
> We are due to go through a major structural change in North America
> in the coming months and years and there will be a lot of broken
> dreams along this road. Inflation is only one of the threats we face
> along this path. There is another though that is frankly a much greater
> danger to the average debtor and home-owner than any other issue
> to date. It will be personal. It will affect every debtor in America.
> And it will devastate the survivors of this current asset destruction
> phase. That looming threat is high interest rates and the trend has
> already begun. And if you doubt that, then just ask yourself this..."If
> historical interest rates are at a bottom right now, then where do
> they have to go but up?"
>
> But that of course is not a rationalization for higher interest rates.
> Higher rates are a function of the market, the global economy, demand
> for capital and risk. And contrary to popular belief the government
> is not in control of these rates. They will be set by market forces
> outside our borders.
>
> Inflation meanwhile is almost certainly in the cards now and this
> point was made lucidly clear with the recent debt monetization. The
> money presses will roll and all attempts will be made to inflate
> our way out of the mess we are in. Inflation (possibly hyperinflation)
> as an alternative to a devastating deflationary depression seems
> OK on the surface but it will actually lead to more wealth destruction
> than any depression could have achieved. Sometimes it is better
> to fight the devil you know than the one you don't. So watch closely
> because the "interest rate" genie will soon be out of the bottle.
> And that monster will bring a whole new round of business failures
> and bankruptcies
> that will make the current difficult situation look quite tame.<br/>
>
> And how damaging will it be? You don't need to look beyond the early
> 1980's to understand how double digit interest rates damaged the
> economy and stifled business investment. This is not to mention how
> home prices were very negatively affected and real fear ruled the
> markets. But housing prices are already being crushed you will answer.
> It can't get worse. Or can it?
>
> Sorry. It will get worse. A lot worse too. The housing bubble has
> burst and market balance will not be restored until it has completely
> deflated.
>
> Consider that for most people, the interest paid on their mortgage
> is the largest part of each monthly payment. Principle payments each
> month are relatively small. If you double interest rates then you
> effectively double monthly payments. But what if they treble or quadruple.
> How many home-owners currently underwater on their mortgages will
> survive even a doubling of their current monthly payments.?
>
> That is the future though and there is not enough bailout money in
> the global treasury to backstop this disaster. This freight train
> cannot be derailed. And I sincerely wish I could say that I was making
> this all up. But I lived through the high-inflation and high-interest
> rate days in the early 1980's. They were brutal and devastating but
> this is really much worse because this time we will (economically
> speaking) be entering into the same situation in a more financially
> weakened state.
>
> How can you protect yourself?
>
> You should consider that we currently have some of the lowest interest
> rates in history. You should, if you have a mortgage, think of taking
> a long term view of the risks ahead. Would you take a one year term-mortgage
> at 6% in this environment if you knew that on renewal you were going
> to be faced with 12% at this time next year?
>
> Think about it.
>
> Even if you keep your job and remain solvent, an interest rate spike
> that doubles your monthly payments could still wipe you out and force
> you into bankruptcy. And you will lose your home too.
>
> This is a real risk that all debtors need to consider seriously when
> renewing lines of credit, mortgages and other long-term debt. <br/>
>
> I would be happy to hear comments from anyone on this topic because
> it is simply not being discussed anywhere at the moment and yet it
> is one of the biggest risks we have going forward.
>
> Cameron

Mar 25 06:06 PM