Why I'm Not 100% Convinced That We've Entered A Bear Market

Historically speaking, U.S stocks are cheap on a P/E and P/B basis. Global stocks are not, by any means. China and India are the worst on a valuation basis, trading at nearly two times 10-year historical P/E and P/B ratios. The U.S, meanwhile, is trading at a discount to its 10-year historical P/E and P/B ratios. The chart below is an interesting slide from the Morgan Stanley report I spoke about previously. The only markets that are trading at a discount to their 10-year historical P/B ratios are the U.S, the S&P 500 index, the MSCI Europe Index, and Japan. It looks a little better on a P/E basis, where all North America and Developed Non-U.S markets are still at a discount to 10-year historical P/E ratios. All emerging markets are still at a premium.

I guess one reason for this may be because the U.S had its run during the dot com era when prices were inflated, which would have bumped that 10-year historical ratio up. Nevertheless, we've still been in about a 4-year bull market, regaining almost all of the losses from the 2000-2003 era. Going out further, we've really been in about a 20-year bull market. Or, maybe all of the historical P/E and P/B ratios are inflated a bit, and have been for some time? If that is the case, then bear market here we come. I don't know...I just don't see how it can go up in a straight line forever -- look at an 80-year chart and you'll see that it doesn't; between 1965 and 1985 it was pretty flat --- with an 80-year time horizon, sure, you'll be fine. But over the next decade, it certainly is not as clear. I truly could see a major correction coming in the next 3 years -- I'm not talking the apocalypse, but something major --- and I imagine it will be a slow, painful death as opposed to a panic sell-off -- or maybe just a flat market...better than a crash, but who wants to earn 0% for three years?

What does this mean? Well, I would speculate (as Morgan Stanley does, so it's not really an original idea), that we will see a pullback, possibly a significant one, in the emerging markets in 2008. China and India would be the most susceptible to profit taking. People have been speculating about the China bubble bursting for a while, so it's not really any big revelation, but this is some of the best actual data that I've personally seen that supports this thesis.

On that same note, it's no news that U.S stocks are cheap; I've heard it in the media quite often. So this is my main concern -- low historical valuations in the U.S may provide some support to the equity markets, which would offset some or most of the negative effects of a recession (to what degree is unknown, but it sure seems like there will at least be a mild recession in 2008). Or, maybe it shouldn't be called a recession as growth and inflation seem to be just fine in general (at least for now)...how about a continued and severe correction in the housing/credit markets? This is my main concern about becoming a full-fledged bear at this point --- U.S valuations may keep them from falling too much further and may, in the end, offer a great opportunity for buying. When it's this close and extremely tough to call or place any major bet, I still think that the best strategy is to just stay long and pick your opportunities wisely (on strength) as to when to add some short exposure. I think that now is still a good time to keep some shorts in the portfolio, despite the Santa Claus rally. Technically, we're up against resistance and still not too far off all-time highs.

The below chart is hard to read, so I've computed the various ratios below that normalize all of this data. Data is current as of November 30th, 2007 and courtesy of Morgan Stanley. The ratios are calculated as current P/E or P/B values divided by 10-year average P/E and P/B ratio.

(To oversimplify it, a value of 1 would mean the market is trading near its 10-year historical value, less than one under its 10 year value...you get the point)

P/E, P/B

• US: 0.71, 0.81
• S&P: 0.66, 0.92
• China: 1.72, 2.42
• India: 1.71, 1.78
• Brazil: 1.42, 2.06
• Russia: 1.19, 1.60
• MSCI EM Index: 1.06, 1.55

Russia looks the best on a valuation basis out of all of the BRIC countries, and Korea and Mexico aren't in too bad of shape either.

click to enlarge

Comments

[Lance]

First, even if we are in a bear market, they are notoriously difficult to play. Slow slides followed by short covering rallies that will make your head swim.

I think you've made some good points, and considered this from several angles. The way I would play this if I was in US equities is pretty straightforward. I'd be oscillating between zero and about 50 percent long, as apparent buying opportunities presented themselves. I would hold the other 50 percent in reserve for the 25 to 35 percent pullback, which may never come, but which is much more likely under the current circumstances than it was before. I think if you go 100 percent long here, at any point near term, you risk getting trapped.

I agree, there is no bubble waiting to be popped. The downside is very, very unlikely to be 50 percent, or 70 percent. But the downside is certainly 20 to 30 percent possibly. Thirty percent off S&P 500 at 1500 is way, way down there at about 1,050. Even 20 percent puts it at about 1200. Anybody willing to have 100 percent get trapped like that? Anybody think it can't happen?

Try 120-dollar oil for starters. Try and imagine what earnings might be like in the next two "earnings seasons".

P/Es are reasonable? Sure, but not cheap. I go back to when they have slumped to 12, or even 10. It happens.

The game is rigged to the upside, and anyone who doesn't realize that is not too clever. But from time to time there is substantial downside risk. This next 6 to 12 months is one of those times, I think. Keep an oar in the water if you must, but don't get sucked in. There are times, not often, but I think this is one of them, that call for more substantial cash reserves than normal. I want to buy at 1100 or 1200. It will take cash. I will have some.

[NoFate]

1) A 17 or 18 PE is historically high for the US. Instead of 10 year, which averages in your 45 PE in the tech bubble, why don't you go back 50 years?

2) PEs are still estimated using forward view ...both Q3 and Q4 earnings growth were cut substantially ...as I am sure 2008 will be as well.

3) Emerging markets have higher earnings growth expectations because their GDP growth is MUCH higher than developed countries. BRIC probably averages 8-10% GDP growth versus the US growth of 1-2% on average. I think EM are also over valued, but not at much as the S&P.

If you are still a bull it is because you choose to be. As they say, "Sold to YOU!"