Staring Down the Bear
July 21, 2002


(Today's modified material appears in green. Here are a few financial links and tables. I'm trying to organize this material to put it all in one place.)

Do not sell into this down market!
    If there is anyone reading this who has money invested in the stock market and who is nervous about their money, do not---now listen to your old Uncle Bob!---do not sell into this down market! As the articles below suggest, we are in the final, scariest phase of a bear market, when the bulls capitulate. (The night is always darkest just before the dawn.) Everything about the bull market of the nineties has been extreme, and this final phase of the bear market of 2002 is turning out to be no exception. The market will have to fall until the last of the rookie bulls give up the ghost and sell their stocks. Only then will the market become cheap enough for an explosive retrenchment of its decline. The fact that panic has entered the picture is music to my ears, and I'm sure it's welcome news for professional investors. But we're now far enough down that the market will assuredly come back up through the point we're at now.

That Sinking Feeling - Smart Money  
Panic Lurks on Wall Street
- Associated Press     
More Selling, but Snapback Seen on Street
- Yahoo Business News  
"We Are Fairly Close to a Bottom"
- S&P
A Perfect Time to Buy? - Business Week  
Is August Worst or Best Month for Stocks?
- Yahoo Business News  

Buy Low and Sell High
    The time to sell equities was at the beginning of this bear market. If there's one lesson I've learned the hard way, it's, "Never sell when the stock market is low." It will come back. Even if we're in a super-bear market, the market is oversold, and getting low-priced enough that real bargains are appearing amid the ruins. Rejoice at bad news. Right now, it's your friend. Many of the first-time investors who have kept the faith through the earlier phases of this bear market are getting ready to throw in the towel, and sell their stocks and funds at fire-sale prices to the pros. You don't want to be one of them. As some of the articles say below, this is the time when the professionals are buying. (Not all the articles say that, or everybody would be buying.) This inevitably occurs at the end of a bear market.

How High Can We Expect the Stock Market to Go in 2004?
    So what kind of rise in the stock market can we expect from here?
    Both Michael Sivy and the S&P website give an estimate for the 2003 bottoms-up operating earnings on the S&P 500 of about $60 a share. That means that right now, this weekend, the forward  P/E  ratio on the S&P 500 is 14, which is in the middle of the normal range  We're interested in next year's earnings forecast because that's what the Fed uses in its fair-market P/E evaluation formula.)
    In 2003, we'll be interested in the earnings forecast for 2004.
    In 2004, we'll be interested in the bottoms-up earnings forecast for 2005.
    In January, 2005, we'll be interested in the earnings forecast for 2006.

What might those earnings forecasts be?
    For 2004, I'm going to guess at earnings of $65-$66 a share. ($2 of that $5-to-$6 earnings increase will be inflation.) Measured against this, the S&P 500 P/E ratio is 13.
    For 2005, I'm going to guess at earnings of $70-$72 a share. Measured against this, the current S&P 500 P/E ratio is 12.
    For 2006, I'm going to guess at an earnings estimate  of $75-$77 a share. Measured against this, the current S&P 500 P/E ratio is 11.

     P/E ratios typically run 20-to-22 at the top of a normal bull market. Using 20-to-22 for an expected P/E ratio in 2004, together with my $75-a-share 2006 earnings guesstimate, I arrive at a value for the S&P 500 of 1,500 to 1,650... about what it was in March, 2000. The reason it's not higher than that is because it went around the bend in the roaring nineties, and I'm assuming that this won't happen again in 2004. In 2004, we'll be coming back to earth after the "wretched excesses" of the nineties. (You may wonder what became of the unprecedented overpricing that I others have mentioned last April. I don't have time to go into it at the moment, but that has been taken into account in these assessments.)

These Predictions Aren't Quite as Rosy as They Seem
   It's worth noting that these numbders aren't as good as they seem. Correcting for inflation, 1527 at the end of 2004 is equivalent to about 1350 at the beginning of 2000. So I'm predicting an inflation-corrected stock market acme in 2004 that would be about 11% or 12% lower than it was in 2000. And if we cranked in the long-term gain in underlying value over the five-year period from early 2000 to, perhaps, early 2005, that would further increase the discrepency between the 1,527 of early 2000 and what I'm forecasting How much is the total discrepency? Of the order of 20%. The S&P 500 index would have to reach 1,825 to
   Of course, that's only with regard to the large-cap stocks. At 1,319.15, the technology-laden NASDAQ stands at about 1/4th the 5,000+ level it registered in early 2000. Its 5000+ high was predicated upon dot.com vaporware, accounting fraud, analysts flogging wildly unsustainable companies, and investor gullibility. I don't think it will be returning to 5,000+ any time soon. However, it's more volatile than the Dow and the S&P 500, and it may give us a good ride. Presumably, share prices of the many good companies that comprise NASDAQ have been dragged down with the Worldcoms and the Global Crossings. I would hope that it might double to 2,600+.
   Still, these outcomes are a lot better than no rebounds at all. The price peaks in early 2000 were brief

Applying the Fed's Fair-Market-Value Formula
    If we apply the Fed's fair-market-value formula to the current situation, the current yield on the S&P 500, at a P/E ratio of 14 is 1/14 = 7.14%. The current yield on the 10-year Treasury bond is about 4.6%, so stocks are a much better investment at the S&P's current level of 847 than are bonds.
    Projecting ahead to  an 11:1 P/E ratio at the top of the coming bull market, I arrive at an earnings yield of 9.1%, or almost twice that of the 10-year Treasury yield. And this is only fair market value. The earnings yield may run lower than the 10-year Treasury yield at the peaks of bull markets.
    One word of caution, though. The yield on 10-year Treasuries can change rapidly. It has dropped a full percentage point since I wrote my articles in April and May. Right now, the Fed is holding interest rates steady, until the stock market recovers from its swoon. But once that happens, up they go! Because the yield on 10-year Treasuries is somewhat mercurial, I feel more comfortable with historic P/E ratios at market extremes, although, unlike historic P/E ratios at turning points, the Fed's formula has the advantage of factoring in the interest rate climate and its effect upon equity prices.

What Am I Going to Do on Monday?
    On Monday, I'm going to play it by ear. Some time soon, I plan to divert some of our ultra-conservative money from its safe haven to technology and communications funds that have been decimated by this bear market. I'll wait on Monday until a little while before closing to see whether the stock market is continuing its slide (thereby allowing me to possibly buy in at lower prices), or whether I want to commit at the day's closing prices to lock in the bargains as I see them on Monday. Of course, in April, I assumed that it had hit bottom on September 19, 2001, and that it would move up from there once the recovery got rolling and the accounting scandals moved from the front page to the back pages. I never dreamed that we would have a chance to buy it at prices below those of September 19th. (The farther down it goes, the safer buying stocks becomes. I realize that we're all losing money as the stock market goes farther and farther down, but trust me: it will come back at least as high as it is now. This won't be the last chance to sell at today's prices.)

Could I Be Wrong About the Stock Market Turning Around?
   Could I be wrong about this? A lot of the reported earnings during the nineties are turning our to be fraudulent. How do we know that current earnings forecasts for 2003 and 2004 aren't fraudulent, too? And what happens if this collapsing stock market slows the economy, making lower earnings a self-fulfilling prophecy? Look at Japan!
   The reason I'm not more worried about earnings than I am is because we're back inside the trend channel again, back in familiar territory, and price-to-earnings ratios are within hailing distance of where they should be, considering where we are in the trend channel. Standard and Poor's estimated earnings for 2002 are $51.23, giving us a current-year P/E ratio of 16.5. That's near the top of the historic trend channel (at 875), and a reasonable number for an S&P index of 847 (Trailing earnings would be a bit lower.). (Actually, earnings during the latter 90's were exceptionally high, and a temporary upper bound for the S&P 500 might be 975-to-1,000.) Accounting irregularities are receiving intense media scrutiny right now. In all likelihood, at least 90% of U. S. corporations have managed their finances close enough to acceptable accounting practices that their numbers are no worse than they've been in the past. So I suspect that Standard & Poor's earnings estimate are reasonably accurate... accurate enough to satisfy investors through 2004.
If the economy shows signs of flagging, I'm sure the Federal Reserve can find ways to stimulate it. Supposedly, the ecnomy is rolling along nicely, although it's the bad news that sells newspapers abd air time. And the U. S. isn't Japan.
    Wouldn't indices of 12,000 on the Dow and 1,540 for the S&P 500 take us well above the upper bounds of their trend channels? Wouldn't stocks be above historical limits at those prices? The answer is: "Yes, they would." However, it's not as bad as it sounds. After factoring in five years of inflation and of 1.4% underlying growth, a DJIA value of 12,000 in January, 2005, would be equivalent to a Dow value of 8,500 in January 1997, and an S&P index of 1500 in January, 2005, would be commensurable with a value of 1,062 in early 1997, compared to an upper trend line value of 725. The S&P 500 number is certainly out of bounds, and the S&P 500 may not get to 1,500 during the coming upsurge.
    The nineties saw an unusually extended period of sustained economic growth, and may have temporarily (or permanently) justified values of the Dow and of the S&P 500 somewhat above their long-term trend rates. A similar justification may prevail in January, 2005.
   Long-term, either we've entered a new era of investing in which the stockmarket is destined to fluctuate at higher valuations than it has in the past, or over the next few years, the market will readjust so that it returns to the trend channel where it has resided since 1871.
   I suppose it's possible that the stock market could continue to sink until it has fallen farther toward the bottom of its range, and has squeezed out out all the inflation of the nineties. The bottom of its normal range at the end of a super-bear market would put the Dow at about 3,000, and bring the S&P 500 down to about 300. However, other economic circumstances are so favorable that I don't see that happening now. That usually occurs in the depths of a deep recession, with inflation running rampant and interest rates running sky-high. I think the odds-on bet is that we're on the edge of a market rebound through at least 2003, and possibly (or even probably, given the length and severity of this bear market), into 2005.
   Novice investors have been warned to expect bear markets and to hang on to their stocks when this occurs. However, a two-and-a-third-year bear market that dips. However, a 32% drop in the Dow and a 45% decline in the S&P 500 (not to mention absolute carnage in yesterday's darlings: technology stocks) have been a heavy gig for "unblooded" investors. Having kept the faith and stayed the course, they have seen their retirement accounts shrink more and more the longer they've held on. You can see why, lacking repeated exposre to these kinds of baths, they're deserting the fold.
   The stock market is a zero-sum game. It's inherently competitive. For every loser, there's a winner. This is the time when the amateurs feel betrayed, and man the lifeboats... just before land is sighted. But this is how it has to work. As long as some of the bulls hang on to their stocks, the market can't go low enough to set the stage for another run-up in stock prices. They've got to get cheap before they can get expensive again.

What Happened to That Price-Inflation Factor of Two That I've Been Touting?
   Shameful shame! Much as I hate to admit it, I goofed. Qualitatively, everything I said was correct, but quantitatively, I was wrong. In early 2000, the upper trend channel for the Dow lay at about 8,000, and at 11,720, the Dow was about 1.5 times the value for its upper trend channel. The upper trend channel value for the S&P 500 was about 820. Since the S&P 500 spiked at 1,527, it was almost twice (1.86) the value of the upper trend channel, which is why my cross-checks supported a factor about two for the degree of overpricing of equities. As described above, the present market pull-backs have reduced these numbers to within (albeit near the tops of) their normal ranges.