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As I sat to pen this missive, the Dow Jones Industrial Average was down 700 points intra day and the decline seemed to be gaining momentum. Logical investors must ask how close the market is to whatever bottom it will eventually reach during the great credit crisis of 2008. While nobody knows for certain, I believe it would be reasonable to assume yesterday’s market behavior is more likely indicative of a capitulation marked bottom than that of the middle innings of a bear market. Multiple indicators are flashing “buy” for many manner of financial assets.

FEAR

No single indicator better measures fear than the CBOE Volatility Index or “VIX” as it is known in industry jargon. The VIX is widely accepted as an indicator of fear in the market place. The index looks at the amount of “premium” priced into certain options contracts and generates an “implied” volatility. Readings on the VIX below 30 are often seen as relatively calm periods in the market, while prints above 30 are indicative of greater volatility. It is widely believed that when the VIX has jumped sharply higher at an unsustainable rate that fear and presumably selling pressure is at a peak. Such spikes in the VIX are traditionally followed by increases in stock prices.

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The VIX index was at 57 yesterday, nearly double the threshold of 30 that indicates investor fear. The greater the fear in the selloff, the larger the potential rebound when fear subsides.

PANIC

Just over one year ago when the credit crisis appeared, the investor class in aggregate chose to ignore much. Even though policy makers and experts talked about the crisis, investors chose to send stock prices appreciably higher. In fact, the DJIA hit an all-time high nearly six months after the term “sub-prime loan” began swirling around in our daily lexicon. At the time, the comprehension of the significance of the credit crisis was largely in front of us and little had been done in the form of recapitalization, policy stimulus, or the passage of TAR.

Now investors are selling with reckless abandon as panic and fear overtake logic. There likely isn’t an investment firm on the planet that hasn’t been given sell orders from a client gripped with fear in the last few sessions. This selling is certainly contributing to falling prices, which instills more fear, which contributes to further falling prices and so on. If one has the fortitude to look at the copious amounts of value in both equities and fixed income today, and the ability to see today’s prices are largely irrelevant to all but this day’s buyers and sellers, then profiting from panic should be the call of the day.

The S&P 500 index of stocks is now trading at 11 times next year’s estimated operating earnings. This type of low multiple is normally associated with very high interest rates. The last time the S&P500 traded at 11 times earnings was 1988 (11.8X) when the risk free yield of the ten-year US Treasury was 9.14%. Today, the ten-year US Treasury is 3.45%. Consider that the dividends alone on the S&P 500 are 2.6%. The last time the dividend yield of the S&P 500 was this high, 1994. In 1995, the S&P 500 rose 35.5%.

A common measurement of value in the stock market is the Fed Model. At times of high confidence stocks become overvalued by the Fed Model. Conversely, at times of fear and panic stocks become undervalued by the Fed Model.

Using the consensus operating earnings estimates for S&P 500 earnings for 2009 of $104, stocks appear to be nearly 60% undervalued suggesting more than 100% of upside potential in the next few years. Of course, this chart could also be suggesting that interest rates on ten-year Treasury bonds are set to rise appreciably or that earnings are grossly over-estimated. At this point, it appears investors believe S&P earnings will decline far more sharply in 2009 than may be reasonable to assume.

OPPORTUNITY

Yesterday’s climactic sell off looks an awful lot like capitulation. High quality companies are being sold in an inverse of Irrational Exuberance. Another compelling piece of opportunistic data is the dividend yield of the S&P 500 earlier mentioned at 2.6%. Despite a horrific year for all things financial, companies in the S&P 500 chose to increase dividends by 4.5% from the prior year. This was a modest increase to be sure but considering the swath of dividend cuts and omissions from the financial sector this increase underscores the balance sheet health of the non-financial sectors of the stock market.

In light of financial uncertainty and declining stock prices, many companies have preserved, indeed hoarded cash. The level of cash on the balance sheets of S&P 500 companies has risen to 31% of the outstanding market value of the stock. This level has not been seen since a 30% reading after the bursting of the technology bubble. This cash can be expected to be put to good use potentially lifting stock prices. Uses include acquisitions, expansion, dividends, and buybacks. Investors could buy iShares S&P500 Index Fund (IVV, $106.59).

Opportunity in bond markets remains high in all areas except Treasuries. Fear and the desire for high liquidity have driven investors to government bonds at any cost. Value in non-government bonds is measured by the “spread” that bonds pay above the yield on the ten-year Treasury. If the ten-year Treasury pays investors 3.6% and a corporate bond pays 6.6%, the “spread” is 3.0%.

Investment grade corporate bond spreads are now over 5.0%. This means investors can get 8.6% by investing in the bonds of investment grade companies. When fear subsides and spreads narrow, one can expect the value of the bonds to rise adding handsomely to the return of the interest payments. ETF Investors should look to iShares iBoxx Investment Grade Bond Fund (LQD, $87.83) with a current yield of 5.64%.

High risk bonds known as High Yield are currently showing spreads greater than 10.0%. The credit risk in this category is greater than in the investment grade arena, but buying when spreads are this high has historically provided investors with substantial returns in the subsequent three year period. In fact, spreads in high yield have exceeded 10% eight times in the past and the mean annualized return in the subsequent three years was 22.4%. The lowest return was 16%. ETF Investors should look to iShares iBoxx High Yield Corporate Bond Fund (HYG, $79.31) with a current yield of 10.1%.

CONCLUSION

The financial strain on the worldwide banking system is significant and I am not denying the severity of the crisis. Within every crisis lies opportunity for patient investors. Investors should resist temptation to panic and take advantage of compelling values presented by an unnerved financial system.

Source: Fear, Panic & Opportunity in the Markets