Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 3-Jul-2008
Stock markets continue downward trend as earnings fall further

Web Log - July, 2008

Stock markets continue downward trend as earnings fall further

Price/earnings ratios have only begun to fall from stratosphere.

"Investors keep selling into rallies" is the complaint from CNBC commentator Bob Pisani. What this means, he explains, is that if the stock market shows any signs of rallying, traders immediately sell in order to make back some money they've lost. The Dow Industrials have fallen 21% since their peak last October.

What pundits are praying for is "a series of good news stories, one after the other." This would presumably make investors more risk-averse again, and would allow the stock market bubble to expand once more.

Pundits are blaming the current stock market plunge on the high price of oil, now reaching $142-143 per barrel on international markets. They point out that the price of oil has been highly correlated (inversely) to the S&P index for the last few weeks.

But I don't believe that. The price of oil has been going up for a long time now, and it's only very recently that investors even cared. Investors don't care about anything long-range. They react to today's news only. And lately, the news has been about oil prices. Next week or next month, something else will be the news, and oil prices will be forgotten.

However, there is one thing that investors do pay attention to: Price/earnings ratios. And the way I know that is by looking at the latest version of the graph that appears on the bottom of the home page of this web site. Here's last Friday's version:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 27-June-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 27-June-2008. (Source: MarketGauge ® by DataView, LLC)

The long range view from the above graph is this: The historical average is 14, but it's been well above average since 1995, indicating that we're in a 13 year old stock market bubble. By the Law of Mean Reversion, we can expect a 13-year long correction.

But there's also a short-range view. Note that the P/E ratio has been around 18 for over two years until recently. This can't be a chance happening. Whatever formula traders have been using, whether it's the "Fed Model" or something closely related, traders must have been purposely keeping the P/E ratio at 18.

There are two possible ways that this could have happened:

Reading the above graphs indicates that probably there's a mix of these two strategies.

It was mid-December when it first became clear that 4'th quarter earnings growth was going to be sharply negative, and it was shortly after that that the S&P 500 index started falling sharply as well. That seems to indicate that Strategy 1 traders were actively selling, just enough to keep the P/E ratio still near to 18.

However, it was three months later, in March, that it first became clear that 1'st quarter earnings growth was ALSO going to be sharply negative. This time Strategy 2 came into play. This was the time when the Fed made the historic move of saving Bear Stearns from bankruptcy, convincing many investors that the worst was over, and the earnings would start rising again. Traders ignored the falling earnings, and assumed that they would continue rising as they had in the past, and P/E ratios began rising to stratospheric levels.

Now let's move ahead three months again, to June. (In case you haven't noticed, we're always talking about the last month in the quarter.) It was in June that it became apparent that 2'nd quarter earnings growth would again be negative, dashing traders' hopes that the worst was over. Since then, P/E ratios have been falling.

How far will they fall in the short run? This brings us back to the "series of good news stories, one after the other," that I mentioned above.

Second quarter earnings for banks and other financial services industry companies will be announced in the next two weeks. If those earnings beat expectations, then there may again be a short-term rally. If earnings are at or below expectations, then the P/E ratio should be expected to fall further, which means that stock prices will fall further.

As regular readers know, every week or two I post the table of S&P 500 average corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters.

Here's the latest table for second quarter earnings:

  Date    2Q Earnings estimate as of that date
  ------- ------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%
  Jun  6:              -7.3%
  Jun 13:              -8.1%
  Jun 20:              -9.0%
  Jun 27:             -11.3%

As you can see, earnings estimates have continued to fall, week after week. It will sure be a big surprise, especially to me, if all of a sudden financial services companies start showing earnings growth.

With Wednesday's 1.46% fall in the Dow Industrials, the market has now fallen to 79% of its peak in October. As can be seen on my Dow Jones historical page, this was the level at which the chain reaction leading to the 1929 crash began. We can't be certain what level is necessary to trigger a new generational crash today, but it seems likely to be somewhere around the low to mid-70s%.

A generational crash is an elemental force of nature, like a tsunami. You'll have millions or even tens of millions of Boomers and Generation-Xers in countries around the world, never having seen anything like this before, and in a state of total mass panic, trying to sell all at once. Computer systems will crash or will be clogged for hours (as has already happened to some systems, incidentally, on February 28), or perhaps even for a day or two. People who had hoped to get out just as the collapse is occurring will be totally screwed, and will lose everything. Brokers and other institutions will go bankrupt. People who went short hoping to make a fortune will find that their brokers' escrow accounts are gone, and they'll be totally screwed, and will lose everything.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (3-Jul-2008) Permanent Link
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