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Kass: Fear and Loathing on Wall Street

Here is a partial check list of signs that I and others are looking for (and their status in italics) as indications for a more favorable stock market:

  • Bank balance sheets must be recapitalized. We await a bank rescue package in the week ahead.
  • Bank lending must be restored. Bank lending standards remain tight. For now, we are in a liquidity trap.
  • Financial stocks' performance must improve. We are not yet there. Financials' performance is still drek.
  • Commodity prices must rise as confirmation of worldwide economic growth. There has been some recent evidence of higher commodities, but it's still inconclusive.
  • Credit spreads and credit availability must improve. While credit spreads are improving, the yield curve is rising and interest rates have rebounded, the transmission of credit remains poor. Time will tell whether monetary and fiscal policies will serve to unclog credit.
  • We need evidence of a bottom in the economy, housing markets and housing prices. The economy's downturn continues apace. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize despite an improvement in affordability indices.
  • We also need evidence of more favorable reactions to disappointing earnings and weak guidance. We are not yet there, but this will tell us a lot about the state of the stock market's discounting process.
  • Emerging markets must improve. China's economy (PMI and retail sales) and the performance of its year-to-date stock market have turned decidedly more constructive.
  • Market volatility must decline. The world's stock markets remain more volatile than a Mexican jumping bean.
  • Hedge fund and mutual fund redemptions must ease. While I am comfortable in writing that most of the forced redemptions have likely passed, we will find out more over the next few months. Regardless, the disintermediation and disarray of hedge funds and fund of funds have a ways to go.
  • A marginal buyer must emerge. Pension funds seem to be the likely marginal buyer as they reallocate out of fixed income into equities, but we have not yet seen the emergence of this trend.

While sentiment and valuation are not the sine qua non in determining share prices, it should be underscored that the current bear market is the second-worst in history, both in terms of price decline and the erosion in P/E multiples. This means that embedded expectations are low. While sentiment, as measured by hedge fund and mutual fund redemptions, remains acutely negative, individual, sovereign and institutional liquidity remains abundant and is growing swiftly.

On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:

  1. The risk premium, the market's earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
  2. Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
  3. Valuations are low vis-à-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
  4. Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
  5. The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
  6. The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
  7. A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.

The most common cause of low prices is pessimism. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling.

-- Warren Buffett

Today's growing investor disaffection and apathy with regard to equities has, at it's root, Hunter S. Thompson's fear and loathing. Both have given voice to the mind-set of a generation that had held high ideals and, as it relates to stocks in 2009, is now crashing hard against the walls of American reality in credit and finance.

If it all sounds familiar, it is, as both the 1960s and the 2000s were the decades of dopes.

After the speculative boom of the 1960s, the U.S. stock market fell into the early 1970s, but the extension of the popularity of the "Nifty Fifty" kept the market in gear for a few more years. After the Nifty Fifty bust in 1973-1974, the markets resumed a modest ascent in 1975, which petered out two years later. By 1982, 12 years after the close of the 1960s, the great bull market of the modern era began, despite loud chants that "the sky was falling" by the increasingly populated community of Cassandras.
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