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Much of the worry on Wall Street lately seems to have been focused on housing and those darn subprime lenders like New Century Financial Corporation (OTC: NEWC.PK) and Fieldstone (FICC). Defaults are rising, and as the real estate market continues to slow and quick-flippin investors realize that there’s no free lunch anymore, the pain is likely to get a little worse.

I think there’s the real potential for some of the mess to spread beyond subprime — I don’t doubt that there were people with good credit that got themselves caught up in the RE madness. While they’re a group less likely to default based on credit standards, the prevalence of stated income and creatively structured loans that allowed people to buy something they may not have been able to afford gives me pause.

I’m not short-selling the sector, though, because I know that not all interest-only loans on stated income are people trying to buy more house than they should. For the self employed or people who live off of a lot of tips, stated income can make legit sense. For others, taking the option of an interest only loan when rates are so low can be a good capital allocation strategy.

All that aside though, what worries me about what’s currently going on is the potential deterioration of sentiment in the economy. Hard numbers are all well and good, but it’s positive sentiment that has people driving to the malls and businesses, upgrading their IT systems.

Some might say that the stock market is currently relatively safe because P/E ratios aren’t particularly high on historical standards (though they’re far from cheap). I don’t disagree that P/E’s aren’t looking exceedingly high, and though stock prices have shown strong growth over the past four years, I wouldn’t say the price growth has been crazy.

What makes me toss and turn a little at night, though, is the strong earnings growth that we’ve seen over the past couple years. It’s been a nice party, but how long can it last? I see merit in the argument that the needed correction after the Dot Com bubble was avoided by the exceedingly low Fed Funds Rate and the housing boom that it sparked. We may now be getting ready to pay that piper.

When you pull the “E” rug out from under the P/E we’re suddenly not sitting so pretty any more. Prices will adjust downward and the lowered sentiment will likely mean that they will adjust down to a lower average P/E than we’re currently at.

End of the world? Hardly. Business and economic cycles are like the weather — they’re constantly changing and you have to deal with the downs to get to the beautiful ups. For long term investors, I’d say that now is a good time to look past the paper value of the stock certificates that you’re trading and think about the ownership interest you have in the underlying business. If you can avoid panic selling in an economic downturn, it’s hard to go wrong owning a piece of a good company.

Source: The Mess Beyond Subprime: It's the 'E' in P/E That Worries Me