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In my article last Wednesday, Why I'm Not Worried About Sub-Prime, I wrote:

Next, ask yourself how much of the U.S. economy housing represents. By the tenor of the news these days, you'd think half of the U.S. gross domestic product comes from the housing market. It doesn't. Housing accounts for a mere 5% of the economy. Even if housing slipped by 50%, the overall economy would suffer only a 2.5% loss. That's not nothing, but it's not the stuff of The Big One. Besides, housing is nowhere near falling 50%, so we're actually looking at a hit to the overall economy of maybe 1%.

Folks, this is no disaster. The stock market is not finished. We're not seeing the front edge of a storm that will demolish all we've built over the years.

In response to that article, L. Morelli from Colorado Springs wrote:

Your comments on the fraction of GDP are quite correct, but what do they have to do with perception in the market? When the dot-com bubble burst, the whole market fell 30%. Why? Did people stop buying soap, toothpaste, or food? Did IBM (NYSE:IBM) add a dot to its name? Were the dot-com companies 30% of the US economy? Hardly!

So, why are you giving the cold facts? They are just confusing the issue. The market had been going up for a very long time without a correction, and the sub-prime issue is a fine excuse to have one.

Is the economy in bad shape? Not at all. Is the job market collapsing? With 4.6% unemployment, it isn't even close. Have companies stopped turning a profit? No, but the rate of increase has slowed down and will presumably stop at some time. If Americans weren't so bad at math, they would realize that any growth rate of 30% has to stop way before it reaches the size of the national budget. House prices increasing at 20% to 30% per year is unsustainable even in the not-so-long run.

But, then, I am making your mistake, using facts to justify my arguments.

A much better issue is why a family with an income of $145K/year buys a house for $900K with $0 down. Income of $145K/year is not chicken feed, but is not enough to pay a mortgage more than six times its value, unless the residents live a life of pork and beans, Goodwill shopping, a 20-year-old jalopy, etc. That's hardly what one expects from people buying a $900K home. And, guess what? They lost the house.

So, is there an explanation for this situation? I can think of three: greed, stupidity, and bad math, none of which is fixable, especially the second. Cases like these are nationwide and it will take a while before we see all the consequences.

In the meantime, the market will gyrate and hopefully offer some real bargains as in the post-dot-com collapse.

I give the cold facts because to the non-stupid out there -- among whom I count most of my readers by virtue of their choosing my material from a sea of alternatives -- understanding the relatively low threat level of the scare-of-the-moment provides confidence needed to buy when prices are low. Keeping the facts handy when emotions run wild is a good way to see if those runaway emotions are providing an opportunity that the more rational can exploit.

Mr. Morelli is right to flag emotions as a key part of market analysis. The only reason price-to-earnings ratios change is that emotions surrounding the stock or index in question change. We could all agree, for instance, that it never makes sense to pay more than 10x earnings for a stock. If we did so, anybody with a calculator could tell you what a stock will trade for at a future date if its earnings estimates are met.

It never goes that smoothly, though. Emotions magnify the distance traveled in both directions. When the news surrounding a company is bad in conjunction with its earnings falling, people sour on it. "It's dead money," they say. "All past and no future. Move on."

The stock might have sported a P/E of 20 prior to the storm, but suffers both a drop in earnings and a drop in sentiment to drive its price lower than is reasonable. If the earnings fell 10% in a rational world where the P/E never changed, the stock price would also fall 10%. In the real world, though, it falls that much and more as the multiple people are willing to pay also drops.

Look at an example.

Say a home building company named T.R. Norton earns $2 per share and has a P/E of 20. Let's prove to Mr. Morelli that not all Americans are bad at math by grasping immediately that $2 earnings times a P/E of 20 gives us a share price of $40. In reverse, a $40 price (the "P") divided by $2 in earnings (the "E") gets us back to a P/E of 20. All clear on the how the numbers relate?

Suddenly, T.R. Norton hits a rough patch in the housing market and its earnings drop a sickening 40%. Improving the image of Americans yet again, we nimbly subtract 80 cents from $2 to get a new earnings-per-share of $1.20. OK all you American math whizzes, if the P/E remained constant, what would the new share price be? That's right: $24.

I know you Americans know this, but for any math-challenged foreigners, I'll explain. The new $1.20 earnings times the P/E of 20 gives us $24. The earnings dropped 40%, so the share price dropped an equal 40%.

That's not how it really goes, though, and here's where our keen math skills reach their limit in the stock market. If all it took were math, professors would be the richest among us. They're not.

What would actually happen is that headlines would report that T.R. Norton is facing the worst business environment it has ever seen, that some analyst somewhere thinks the housing market may never recover, and that the company president recently sold a bunch of shares.

Now, we've got a company that nobody wants. Out go the calculators, in come the animal spirits and bar room commentary until nobody's willing to pay 20x earnings anymore. Are you kidding? For such an out-of-luck, no-future, dead-in-the-water piece of junk as T.R. Norton?

So the multiple drops. Instead of paying 20x earnings, investors are willing to pay just 12x. Take $1.20 earnings-per-share times a P/E of 12 and you get a new share price of $14.40. The earnings shortfall brought the share price down 40%, and emotions brought it down another 40%. Understanding emotions, something even the best calculator won't help you do, was just as critical to analyzing this situation.

When the turnaround arrives, it all happens the same way in reverse. The earnings improve, the news brightens, the image of the company turns up, some analyst somewhere thinks housing looks great for the next five quarters, the president invests a million dollars in the depressed stock, the bar room talk turns in favor of ownership, the multiple expands back to 20, and you get a raging climb in the share price. That's the cheery consensus Warren Buffett talks about being absent among low prices.

Keep the facts in mind because they'll help you see the good news waiting to happen down the road. Once you know the facts, watch how current emotions are ignoring them and take advantage of the discrepancy.

Source: The Cold Facts Help Identify Buying Opportunities Amid Emotional Upheaval