The Economy is Still Deteriorating, But What Will the Markets Do?

It is official; government economists have declared that we have been in a recession for over a year. Of course anyone living in the real world knew we were in a recession long before economists and the government officials. What started off as a housing market crisis morphed into a credit crisis morphed into a global market meltdown and finally caused the demise of the banking system as we knew it.
So we now have been through two bubbles (dot com and housing). I call them the twin peaks, or the Grand Tetons of the stock market (see chart below). Bubbles are always obvious in hindsight, after they burst. If you look at the stock market before the twin bubbles (pre-1995) and extrapolate forward at a more reasonable growth rate, maybe the current level of the market is not far from where it would have been if we had just experienced reasonable consistent growth.
The market and economy tend to swing like a pendulum. If the market swings go too far up then it must over-correct with equal force in the opposite direction. Corrections are usually just as severe as bubbles were frothy. So the recovery from the twin peaks bubble will not be a quick V-shaped one as many are hoping. This is going to take a long time and is not a normal cyclical recession. This recovery will necessitate the complete restructuring of our financial system.
It will take years to resuscitate the U.S. economy and 2009 will be terrible from an economic perspective. It is also clear that when we do recover our economy and banking system will be transformed. It has already begun with a string of bank consolidations and some bankruptcies. In order to keep the banks solvent, the U.S. government is being forced into taking large equity stakes in all the major money center banks just to keep them afloat. It is obvious that the banks need to find a new business model and ominously it will not be as profitable as it was before.
The government will insist on new regulations that will keep the financial institutions from assuming such substantial risk. In fact, the government will want the banks to adopt a business model not unlike that of a utility company because it has become clear that the economy cannot accommodate the failure of our largest financial institutions. The impact on our economy will be immense. Since the 1980s, the financial sector has driven the economy. It called the shots and became larger than the manufacturing sector. In fact it, told manufacturing and every other sector of the economy what to do. Our whole economy will now have to restructure and our growth rate will be lower as a result.
Our government’s response to the crisis has been to throw money at our financial institutions in the hopes of dousing the fire. As with any emergency action there will be unintended consequences. Instead of water and foam being dispersed everywhere to douse the fire, the Federal Reserve and Treasury are using cash. Some institutions will survive that should have been left to wither and others will fail though they deserved to survive. Government support is always inefficient, but in this case there was no alternative. To not have acted would have led to the complete failure of the banking system and our economy.
The government is now shifting its response to the credit crunch. The banking system is too damaged to recover quickly. So the Treasury will change gears and begin to purchase broad asset classes and in some instances extend further guarantees. The Federal Reserve and Treasury will also have to implement additional strategies to inject the needed liquidity to businesses and consumers and bypass the banking system. These actions change the investment landscape and shift our near term investment strategy to focus on assets the government is supporting. In this environment bonds are preferable to equities (stocks). So unlike most recessions, equities will not lead the way out of this morass. So unlike almost every bear market of the past 50 years, buying stocks after more than a 20% decline might not be the best move this time around.
At current levels stocks may look like a bargain, but are they? It depends on which metrics you use and a stock’s promise. The promise of a stock is its ability to meet or exceed its current projected earnings. The measure frequently quoted is Price to Earnings ratio, which compares the price of a stock to its trailing (last period’s) or forecasted (estimated future) earnings per share. Investors focus on future performance and therefore use forward earnings to calculate the price to earnings ratio. Trailing earnings are used to assess the reasonableness of future earnings. Unfortunately, it is tough to assess value or estimate future earnings in a volatile market. Using trailing earnings (earnings from last year) causes the Price to Earnings ratio of stocks to seem cheap (see chart). However, earnings are falling, rendering trailing earnings an un-realistic gauge of current value.

The problem is that Wall Street is still too optimistic about earnings even though expectations for the future quarters have eroded quickly. On Oct. 1, according to Thomson Financial, the Wall Street consensus was that S&P 500 earnings would rise a whopping 47% from the fourth quarter of 2007. Now, analysts think earnings actually fell 23% from a year ago. If their new forecast is correct, earnings will have fallen for six quarters in a row, the worst stretch on record. But analysts are still gung-ho about the future. Analysts expect S&P 500 earnings to be roughly flat this year, according to Thomson, but post a 33% year-over-year rebound in the fourth quarter. These forecasts depend on a quick economic recovery, which is unlikely to occur. Most economists expect something more sluggish at best.
Equity analysts tend to always be too bullish about the economy. Since the earnings slump began in 2007, analysts have consistently held high hopes for profits a year out, while busily cutting forecasts for the quarters immediately at hand. The pattern seems to be continuing in 2009. The bottom line is that at current levels the stock market has already priced in a 30% decline in earnings. So even though analysts can’t face the truth, the market already has. Are stocks cheap? Many metrics suggest that stocks should at least provide satisfactory returns going forward and possibly something better, but owning the stocks that can deliver on their future earnings promise is the key.