The Beginning of the Next Bull Market? History and Earnings Say Probably Not.

“[It is] an ill wind that bloweth no man to good.”

-- John Heywood 

I’ve heard a lot of discussion in recent months about the future of the dollar and the economy. Some people think this is just a typical downturn – that we’ll get through it and then everything will be just fine. Housing prices will rise again. The stock market will recover. The United States will prosper. Everything will be as it was. Similarly – and more recently – there has been a plethora of talk about whether the recent rally in the stock market is the beginning of a new, long-term bull market.

I hate to yet again be the harbinger of bad news, but this is not the beginning of a new bull market, and things are not going to be as they were.

Have a look at this chart comparing the stock market collapse of the 1930s to our current downward spiral, created by Mark Lundeen:

 

Mark has consistently painted a cogent argument that we are nowhere near the bottom. If you haven’t already, you would do well to read his articles going back a year or two. He predicted everything we’re going through in a humble and patient manner. Even if you’re determined this market is going to turn around and return to “normal,” I’d think twice before simply dismissing his research. In any case, no matter what your outlook is for the future of markets and the economy, the focus of this article is the current stock market rally. And the thing that should be jumping out at you, regarding the chart above, is the red plot – explicitly, the sheer number of false rallies the market endured from 1929 to 1932.

Before we go further, I want to remind you that I found my success in the financial world as a value investor. I believe wealth-creation is a long-term prospect, and if an investor wants to do well, he or she must find undervalued enterprises that create abundant free cash flow. But more than anything, that investor must enter the position at a discount to intrinsic value. So what is intrinsic value? It is a discounted measure of a firm’s ability to create wealth for its owners, over time. And in my world, wealth is measured explicitly by free cash – loosely derived from a company’s earnings.

The problem with the current economic environment is manifold. Sure, in terms of simple aggregate stock prices, global markets have been crushed, and on the surface -- to less scrutinizing eyes -- the whole thing probably seems like a giant orchard full of low-hanging fruit. It’s simple, right? You have earnings. You have price. If the price goes down, the company is worth more, intrinsically, because the price-to-earnings ratio has collapsed. Simple, right?

The question is rhetorical, and you’ve undoubtedly guessed that my answer is a resounding no. When the market took its first harrowing dive in 1929, reported earnings remained intact, driving price-to-earnings ratios much lower. To a novice value investor, this might have seemed like the opportunity of a lifetime. Of course, we know now that it was anything but the opportunity of a lifetime; over the ensuing few years, as conditions worsened, earnings reflected the true nature of the economic environment and melted accordingly. Stocks continued to fall accordingly, with very short-lived respites offered by the painful bear market traps I referred to in the chart above.

What caused these traps? The exact same mistakes would-be value investors always make after every downward move in a collapsing market driven by a faltering economy: stocks fall, but earnings do not follow immediately, and this makes everything look “cheap.”  Unfortunately, earnings always lag the market, so when equities fall, the real economic conditions aren’t reflected by historical reporting.

Of course, in a prospering economy, this all becomes moot because earnings will continue to grow despite any market downturns. In October of 1987, for instance, the market shed 23% of its value in one day, but the economy was booming. Anyone picking up equities the day after the crash found some incredibly undervalued companies -- because earnings were increasing throughout the economy. But there is absolutely no comparison between the 1987 crash and its economy with either the 1929-1932 crash, or the 2007-2010 crash, and anyone foolish enough to even consider buying equities at this point needs to take a long, hard look at the economic conditions underpinning our current depression:

1.       The housing and credit markets are terminal. To bring it into perspective, consumers drove 67% of the economy until a year or two ago, and they got the money from their houses and credit cards. That party, however, is over, and the spending has come to a halt. Is this fully reflected in company earnings? Absolutely not, and the worst is yet to come.

2.       The depression of the 1930s was the worst economic catastrophe the U.S. has ever seen (yet), but even in the midst of that torturous environment, the nation was a net lender, and it had a huge manufacturing base. Today, the U.S. is the largest debtor nation on earth, with a relatively small manufacturing base. Whether you agree it was the best move or not – and I don’t – the United States essentially borrowed its way out of the Great Depression -- simply because it could. That, coupled with its powerful manufacturing sector of the time, allowed the country to muddle through some extremely painful years. In the current environment, however, the government’s debt-load is at record levels, and its ability to borrow is severely limited. If you believe that China and Japan are going to continue to lend to the United States at yields between zero and three percent, indefinitely, I would like to know why. Are they really so reliant on the U.S. consumer to buy their exports? And that leads inevitably to the question: what consumer? Please see my previous bullet point.

3.       In the 1930s, the United States dollar was tied to gold, thereby limiting the government’s ability to flood the market with printed currency. I have no doubt that Franklin Roosevelt and his henchmen would have loved to print money to battle collapsing prices caused by the same deleveraging forces we are seeing all around us today. Unfortunately they couldn’t – at least not the way the Fed is doing it now --  and the country was spared the runaway price-increases that would have certainly ensued if the government had been able to print money at will. Today, there is no gold standard. The U.S. government is running wild -- printing money like a child with carte blanche in a candy store -- and that money will have to be soaked up somehow when the deleveraging stops. How will the government do that? By selling Treasuries? To whom, and at what yields? Please see my previous bullet point.

When you compare our current situation to the Depression of the 1930s, the outlook is certainly grim. And yet, in terms of the stock market and its close relationship to corporate earnings, the prognosis is even worse; in the 1930s, the government’s ability to inflate the dollar was impaired, and so, at the very least, prices continued to fall – giving the consumer at least one thing to be happy about. Sure, corporate earnings fell, but at least money retained its value. In today’s economy, however, inflation is the name of the game, and runaway price-increases loom like the darkest storm on the horizon. At this point, it isn’t a matter of if, but rather when the nightmare begins; its inevitability is simply terrifying to those of us who refuse to bury our heads in the sand and trust the very government that created this hopeless fiasco in the first place.

I suppose some would argue that rising prices will be good for corporate earnings, and this will undoubtedly be so in nominal terms. But if the consumer is feeling the pain now, how is he going to feel when the prices of milk and eggs start moving up exponentially? The truth is, in nominal terms, the whole stock market might actually rise a little, but as a long-time value investor, I’m here to tell you that will not mean that wealth is being created for shareholders. If the consumer isn’t spending now, what is his budget going to look like in a hyperinflationary environment? No, in real terms, corporations are facing years of unprofitability -- thanks to the profligate and reckless actions by the United States federal government, among others -- and stock prices are going to reflect that, in real terms.

So when you’re thinking about “buying the dips,” or dollar-cost-averaging into equity markets, try to remember that we are in uncharted territory. The U.S. consumer-driven economy simply has no more fuel, and nothing will change that – at least not for many years. Likewise, the onset of inflationary price-increases is indisputable and inevitable; a country cannot wantonly commit itself to $12.8 trillion and simply print its way to its objective without suffering the enormous consequences of massive price-escalation. Further, this condition will hang in direct contrast with the economy of the 1930s, which was, to say the least, bad enough. I can only imagine how bad an inflationary depression is going to feel.

Ultimately, corporate earnings are headed for disaster, and that won’t be good for anyone. But it certainly doesn’t bode well for the prospects of true value investors.

If you want to know more about when I will be interested in equities again, see my article on the Dow-to-gold ratio.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco will be giving a workshop entitled The Death of the Dollar: How We Can Survive the Coming Collapse at the 21st annual Las Vegas Money Show, Mandalay Bay Resort, Tuesday, May 12, 2009, at 11:30 a.m. He hopes to see you there. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.