Stock Valuations Still Have Downside Potential

By SeekingAlpha July 31, 2012, 07:16:23 AM EDT

By Steven Vincent :

The current technical setup in US markets bears striking resemblance to that which prevailed at the 2011 highs and there are also some comparisons to the early stages of the 2007-2009 bear market.

There's a good possibility that the current bear phase that began in early 2011 is itself a five wave ABCDE triangle and that we are presently in the C leg down of that formation. This would allow for a panic bottom similar to the 2010 and 2011 episodes, followed by a D wave rally spurred by monetary action into a technically oversold market and then followed by a final E of E decline, thus ending the long term Bear market that began in 2000. This would certainly be the resolution that would serve to frustrate and whipsaw the maximum number of traders and investors, bullish and bearish alike, for the longest period of time (which as experienced traders know is the ultimate function of the market).

At this time there is far too great a bullish consensus on the part of active market participants to mark an end to the long term bear market. There is nothing even remotely approximating the psychology of fear and loathing found at the 1982 bottom at this time, but there certainly could be with one more good washout decline. Premature bulls would then exit the market in disgust, vowing never to return.

There's no doubt that in 1981 many bullish analysts were confronted with a similar set of circumstances and presented similar arguments such as we find today. They knew that stocks were hated, that the public was out, that the economy would eventually turn, that gloom and doom prevailed. They saw that P/E ratios had come down well off their highs and had even arguably fallen into territory that normally marked a buy point. Ultimately, they were proven right, but not before being wrong for over a year and 25%.

(click to enlarge)

Then, just as now, there were bulls who were just as certain that a 25% decline could not happen and bears who were certain that a collapse similar to the period of the Great Depression was inevitable and unavoidable. The market found a way to prove both outlooks wrong. Based on my current analysis, I think we will see a similar resolution this time around as well.

This piece by Doug Short explains the trouble that many analysts are having when trying to factor P/E ratio and earnings into their market view. His chart of Cyclically Adjusted Price Earnings Ratio (( CAPE )) shows that while the ratio may be substantially lower at this time, it is not at lows which correlate with long term bear market buy points:

(click to enlarge)

Using Robert Shiller's source chart, we can see that, as at the 1976 and 1981 highs, there is certainly room for a final E wave decline in the ratio:

(click to enlarge)

I might also add that bulls are fond of citing "record earnings" as a justification for buying into the current market. That seems to buck common market wisdom. I would be leery of a strategy that calls for buying at a performance peak, particularly when that peak has come about primarily as a result of cost cutting rather than growth.

The following studies indicate that it may be time for an earnings recession that will accommodate, together with a stock price decline, a CAPE valuation correction to levels similar to those seen in 1932 and 1982:

(click to enlarge)

(click to enlarge)

"Disasterist" ultra bears should be cautioned as well. While I think that the evidence for a significant drop from here far overwhelms any evidence for a significant rally, Uber Bears are also likely to be disappointed with the depth and severity of the decline. Worse, an inability to see the other side of the market will blind them to the ultimate bottom when and if it should arrive.

This interview with the former Reagan Administration budget director is a compelling presentation of the Super Bear case:

Personally, I favor his philosophical outlook and I would prefer to see his worldview proven correct and see the Keynesian Monetarist view proven wrong. But wasn't this argument made throughout the 1970s and early 80s? Haven't we been told that the fiat monetary system is "unsustainable" for over 40 years? Yet somehow, some way, the monetary magicians have been able to pull the proverbial rabbit out of the hat time and time again.

My current sense is that once again, at the end of this cycle, the funny munny gang will have found some way of extending and pretending the scheme for another 4-5 years, much to the chagrin of the sound minded David Stockmans of the world. While it's certainly far too soon to make any firm projections in this direction, I see the potential for Dow 18,800 by 2017 which would then, finally, mark the top of the grand bull cycle that began in 1932. The piper will be paid, but the bill may not come due for another 5 years or so.

Disclosure: I am short [[SPY]].

See also Modine Manufacturing CEO Discusses F1Q13 Results - Earnings Call Transcript on seekingalpha.com




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.


This article appears in: Investing, Stocks

Referenced Stocks: CAPE, DIA, IVV, SPY



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