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Home » Writer's Blogs » JohnPetrick Estate Planning Blunders of the Rich and Famous John Petrick (284) John Petrick Perennial Financial Services Too High, Too Low or Just Right? Posted Wednesday, April 08, 2009 (230 days 10 hours ago.) Viewed 22 times. Experts have long acknowledged that the financial markets are dominated by two key emotions: fear and greed. Many believe that greed led the markets to new highs back in October 2007. Since then, investor psychology has been pounded so badly that fear has helped drive the market to levels that have created unprecedented opportunity. The key question to address, therefore, is how can an investor determine true valuation and whether or not stocks are overvalued based on irrational exuberance (greed) or undervalued based on panic selling (fear)? Since the beginning of Wall Street, investors, money managers and analysts have sought the answer as to how to value the overall stock market. For decades, Wall Street aficionados have used a basic price-to-earnings (P/E) ratio as a basis for valuation. P/E ratio is first determined by a company's earnings per share (EPS) which is calculated by taking a company's net earnings and dividing by the number of outstanding shares of stock. By dividing the price of the stock by its EPS you derive the P/E. So if the markets truly were overvalued in October 2007, it should be safe to assume that P/E ratios then would be much higher than now considering the markets have plummeted more than 40% in the last 18 months. Believe it or not, P/E ratios have risen in recent months. In fact, according to data compiled by Yale University Finance Professor Robert Shiller, P/E ratios in February were higher than 97.8% of the monthly readings dating back to 1871. The reason being that in times of recession, earnings tend to fall even faster than the market itself. So no matter how fast the "P" falls, the ratio will raise if the "E" is falling even faster. A good example would be to look at the latter months of the 2002 bear market when, according to Shiller's data, the S & P 500's P/E ratio soared to just over 45. For that reason, valuing the market based on P/E ratios can be considered flawed: How can you determine the price for a company's stock if you can't determine how much they will be able to make? The stock market is a forward-looking vehicle and P/E earnings are based on the trailing year, so it's much like looking in the rear view mirror. Considering that current P/Es are old news, many investors rely on forward P/Es as a tool to justify the future possibility of growth and economic recovery. For guidance regarding future earnings, investors look to financial analysts who follow the companies and base their estimates off of past performance and future considerations. Still, on a relative basis, what we have seen so far still doesn't compare to what we saw in the 1970s and 1980s. And based off current forward P/E estimates compared to that era, we could be hit by another 25 to 30% decline based on worst-case scenarios. In my October Dollars and Sense article, I discussed how analysts were predicting a growth rate of 20 to 25% in S & P 500 earnings, which I claimed seemed to be "exceedingly optimistic." Recently, Goldman Sachs lowered its estimates for the S & P 500's 2009 cumulative earnings to $63 (the total earnings of all 500 companies), actually assuming a slight decline to actual 2008 earnings. Based on these considerations, Professor Shiller created a cyclically-adjusted P/E ratio (CAPE) which attempted to normalize economic cycles by using a 10-year average of historical earnings to adjust for the effects of volatility on short-term earnings. In March this year, the, S & P 500 traded at a CAPE of 12. Historically, the average long-term CAPE is around 16 (which would equate to 920 in the S & P 500) and the market bottom CAPE in the last 15 economic recessions was approximately 10.8 (or approximately 620 in the S & P 500). As a point of reference, the S & P's low point this past year was 666 on March 9, and it closed on March 27 at 815. A third P/E ratio exists in the form of Price-to-Peak Earnings (PTPE). Peak earnings can easily be described as the highest reported earnings during an economic cycle. During normal economic expansion, corporate earnings tend to rise; therefore a traditional P/E ratio would be appropriate because the past 12 months would translate to the peak of earnings. However, when earnings begin to decline based on a cyclical contraction in the economy, PTPE would be the highest previous 12-month earnings from the previous cycle. Put simply, peak earnings allow investors to look beyond cyclical economic downturns and focus on the long-term return to normalized growth. When the S & P 500 hit 666 on March 9, levels not seen in over a decade, the PTPE ratio was approximately 7.5--the lowest since the mid-1980s. During turbulent times like this, some investors like to acquire hard assets like gold rather than paper assets like the dollar. Rather than focusing on corporate earnings, they use the Dow/Gold Ratio, which focuses on the number of ounces of gold it would take to buy one share of the Dow 30. Historically, there has been a negative correlation between the stock market and the price of gold: when one goes up the other tends to go down. The Dow/Gold ratio peaked in the mid 40's in late 1999 in the midst of the dot.com bubble (when gold traded near $250/ounce). On March 9 this year, the Dow closed at 6547, its lowest levels in over 12 years while gold closed at $923.75 an ounce, a ratio of just over 7. This is a typical shift by investors from a growth phase to one of preservation. Most likely, we can see the ratio bottom somewhere around 5 or 6 based on historical average bottoms, but the question remains: Will it be due to a dramatic increase in the price of gold, a drastic decline in the value of the Dow or will there be a middle ground between the two? So what does it all mean? A market is made by buyers and sellers; therefore when one believes an investment product is cheap, another believes it's expensive. Many fear mongers would lead us to believe that we are revisiting the Great Depression but I don't buy it. Recent unemployment reports show us at 8.1 %, compared to 1933 when unemployment peaked at 25%. At its low point, the economy (gross domestic product) was down 25% from its 1929 high. Today we are nowhere near that. More importantly, there were no social safety nets in place back then. Not until 1935 did the government offer unemployment insurance. There were no food stamps, no Medicaid and most importantly, not until 1933 was a bill introduced to federally insure bank deposits. A combination of those factors lead me to believe that the "worst case" scenario is off the table. That being said, the aforementioned ratios show that the markets are cheap on a historical basis. The absolute lowest S & P 500 traditional P/E ratio was registered in September 1974 at 7. Single-digit ratios like this have been recorded on only four other occasions: in July 1982 (just a month before the start of the great bull market), February 1948, April 1942 and June 1932. If 2009 proves to be another case of single-digit P/E, using a cumulative average of the previous five occurrences multiplied by Goldman Sachs' estimates, we could see the S & P 500 as low as 510 before we finally hit bottom by the end of 2010, but this is assuming a worst case scenario. CAPE indicates that we could see the S & P 500 as low as 500 if we use comparisons to the 70s and 80s. However, there are key differences, namely interest rates and investment alternatives that cause me to be skeptical of such low levels. In 1974, investors could earn 8% on an essentially risk-free Treasury bill; in 1982 they could earn nearly 12% on the same investment. Today, the return is next to nothing, so the alternatives are limited. With limited alternatives, investors have turned their sights to gold, which with a combination of fear, excessive government spending and historically low interest rates seems to be a logical substitute. With the Dow/Gold ratio trending towards 5 or 6 and gold trending towards $1,200, we can assume the Dow could find some support between 6,000-7,000 (it was as low as 6,440 intraday on March 9). One thing is clear: the government seems to have learned its lesson from the days of the Great Depression. This is not another Great Depression! But by no means is it a pretty picture out there. The economy will continue to get worse before it gets better. Unemployment will continue to rise; earnings will continue to decrease as consumers continue to tighten up spending habits. In January, I said the market will resemble a bouncing ball and the move we are witnessing right now is an upward bounce. This will likely be followed by a sell-off where we retest the lows set just weeks ago. This will be a critical point where the markets will determine whether a bottom truly was set earlier in March. The recent actions by the Federal Reserve have sent mortgage rates plummeting to historic lows and have now set the stage for real estate to find some renewed interest. As I previously stated in both October and January, the real estate market was a major contributor to where we are now, but a slowdown in declining values and ultimately price stabilization will be a major contributor to getting us out. I maintain that your portfolio should be diversified with more than just stocks, bonds and cash. It is critical to have hedges in place to help protect your portfolio from excess volatility. However, these investments can also be risky, so make sure that this portion is appropriate for your individual risk tolerance. Use this bounce in the markets as an opportunity to revisit your goals, risk tolerance and time horizon. It is essential to have a plan and stick to it regardless of short-term fluctuations. Don't let your emotions control your decision making, because cooler heads will prevail. The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. John Petrick is a Registered Representative with and Securities offered through LPL Financial. Member FINRA/SIPC. He can be reached at 310-445-2504. Permalink         Comments (0) Assessing the Bailout and Your Investments Posted Tuesday, October 07, 2008 (1 year 48 days ago.) Viewed 20 times. With the financial and housing sectors near meltdown, the government has been taking steps not seen since the Savings and Loan crisis in the late '80s. What started as a fairly simple three-page proposal from the Bush Administration effectively giving the Treasury unconstrained power to coordinate a bailout of the country's financial system ended on Monday. As the vote was shown on TV, stocks plunged and investors fled to the safety of the credit markets, worrying that the financial system would now keep sinking under the weight of failed mortgage debt. Lawmakers voted down a plan that was different than what the Bush administration had originally proposed. The Treasury would have been permitted to spend $250 billion to buy banks' risky assets, giving them a much-needed necessary cash infusion. There also would be another $100 billion for use at president's discretion and a final $350 billion if Congress signed off on it. In response the markets turned highly volatile as it became clear the measure wouldn't find the necessary support. At its low, the Dow Jones Industrial average broke its previous record for an intraday drop set during the first trading day after the Sept. 11, 2001, terror attacks. Still, in percentage terms, the decline of 7 percent remained well below the more than 20 percent drops seen on Black Monday of October 1987 and the Depression. Originally deemed a Troubled Asset Relief Program (TARP) by Treasury Secretary Henry Paulson, the now Emergency Economic Stabilization Act of 2008 (EESA) was created to essentially empower the Treasury to purchase distressed mortgage debt. Similar to what we saw during the S & L crisis, the Treasury had planned to set up a holding company to house these mortgages akin to the Resolution Trust Corporation (RTC) created in 1989. The RTC was handed the responsibility to dispose of the bad loans created by the savings and loan crisis. The RTC took into receivership financial institutions that had shifted away from traditional home mortgage financing and had overextended themselves by getting into new, high-risk investment activities. It pooled all of the bad loans, separated them based on quality and sold them off in tranches by auction. From start to finish the procedure took six years, but by taking control of the assets and controlling the sales of the assets the government was able to contain the costs to taxpayers by preventing a fire sale via a distressed liquidation process. The U.S. General Accounting Office estimated the final cost of the crisis to be around $160.1 billion, about $124.6 billion of which was directly paid for by the government, or in other words, the taxpayer, either directly or through charges on their savings and loan accounts. Did it work? The outcome could be highly debated. Some claim that since the RTC eventually needed much more money than initially projected, this led to big costs to the taxpayer which in turn contributed significantly to the budget deficits in the early 1990's. However, between its enactment and its dissolution in 1995, the RTC was responsible for the closing of 747 thrifts with assets totaling $394 billion. This accomplished what the RTC set out to do: End the crisis, which like today, was threatening a massive drain not only in the but throughout the global economy. In the early to mid-1990's, lower interest rates and a slightly improving economy eventually eased the choke hold on the thrifts and we began to get out of the woods. Had it passed could the EESA do the same? Clearly, economic growth has slowed, but it has yet to contract meaningfully as it is likely to do if acute steps to avert a deepening of the financial crisis are not taken. However, there are clear differences between then and now. Primarily, the underlying assets of the brick and mortar S & L's were reasonably easy to price and sell. On the other hand the values of numerous, confusing, complex financial instruments today are far more difficult to assess. The RTC took over hard assets by taking control of the failing banks, whereas the actions today consist of taking over the banks failing assets. Is $700 billion big enough? Will breaking up the $700 billion into numerous smaller tranches abate the impact of the plan? Under the agreement the government would have only been responsible for buying mortgages originated on or before March 14, 2008. Had the EESA passed, its success would have contingent on whether or not the capital infusion was large enough to have had the capability to buy an enormous amount of "bad debt." It wouldn't have necessarily had to buy all of the "bad debt," but it would have had to clearly show that it is capable of doing so. The current pressures of the market have forced selling on these mortgage securities and has quite possibly pushed their price below the true fundamental values. Similar to the steps taken in the RTC, there will need to be some sort of government action and it will be essential for the government to acquire these assets to alleviate the fire sale, but they must purchase them above current values to entice the brokers to sell them, yet the purchase price must still be below the fundamental value in order to avoid overburdening the taxpayers. The accomplishment of the aforementioned steps should have effectively stabilized the financial markets and stopped the free-fall in these mortgage-backed securities. The hope would have been that passing such a bill would ultimately alleviate the pressure banks have been feeling amidst the credit crunch and begin to create additional liquidity in the markets. Why it didn't pass? Over the weekend there had been much debate over executive pay, government oversight, taxpayer protection and assistance for troubled homeowners. It seemed that by Monday morning most of the above had been agreed upon excluding an effort to give judges the power to modify mortgage terms for people who had filed for bankruptcy. Warnings from the President, the Secretary of Treasury and the Chairman of the Federal Reserve that the approval of the plan was essential to the future of the economy were dismissed and so was the EESA. Some major concerns were that this program, much like the RTC, was a bailout and would have ultimately fallen in the lap of the taxpayer. In an effort to alleviate the long-term burden, taxpayers would have been given an ownership stake in companies whose bad assets were purchased. That in itself proved to be a big issue amongst voters who felt it was a big step away from the basis of American capitalism and a step closer to socialism and could set a scary precedent for the future. The government had already moved in and taken Fannie Mae and Freddie Mac into conservatorship in step that many had viewed as a step towards nationalization. Another concern was one purely political in nature. With the elections around the corner and the constant talk of "Wall Street vs. Main Street" many elected officials felt the bill was viewed negatively by the majority of their "" constituents and a vote for the bill could mean a vote against their future employment. This egocentric view may have easily swayed some from their true beliefs and led them to vote differently from what got them elected in the first place. This may ultimately prove to be a positive. Many felt that the original bill, even after modifications, was thrown together hastily and hadn't been thoroughly thought through based on the short time horizon they had been given. This should provide more time for lawmakers to brainstorm and put together a deal that if passed can ultimately prove more effective in the long run. What now? As we look to coming days, weeks and months ahead, the EESA will likely be revisited and reconstructed from the ground up with Monday's market failure in mind. It can be assumed that many in the House needed to see the violent upheaval the markets showed to have a better understanding about just how important some sort of plan is. Once there is an agreement and a plan is passed, it should prove to be positive as the uncertainty surrounding the financial markets will be alleviated. In the meantime, the declining property values, worries surrounding the credit crunch coupled with a global economic slowdown will most likely lead us into a recession (if we aren't there already) by year's end and likely through much if not all of 2009. It is important to keep in mind that financial markets are forecasting instruments; and with that the stock market historically bottoms well ahead of the end of recessions. Typically, markets tend to gain 25% off their lows before a recession was over. A good example would be to study what happened during the creation of the RTC. The S & P 500 bottomed in October of 1990 following the creation of the RTC in 1989. The economy went on to experience a recession in the second half of 1990 through early 1991. That's the good news. The bad news is that this isn't 1989 and this isn't the S & L crisis. Today's plan will likely be much grander in scale. The original estimates on the failed EESA were over four times bigger than the RTC. Currently, Wall Street analysts' consensus expectations are for the S & P 500's corporate operating earnings per share to grow at a pace between 20-25%, with economic growth slowing and likely to remain below average this seems to be exceedingly optimistic. What should this mean for you? Recently, panic has set in and almost everyone wants out. One benefit the stock market provides that real estate doesn't is liquidity. Selling your house can be a time consuming process sometimes taking months before you've closed escrow and received your check. With the stock market you can have your cash in a matter of seconds. With emotions running high, this can quickly lead to panic and panic can lead to ill advised decisions. The S & P 500 index has been used as a broad-based benchmark of stocks since 1926. On average, annual returns over this period were around 10% a year. But in most years they were anything but "average." In actuality only four times annually did the market fall within the range of 8-12%. That being said, the market as a whole moves in bursts, both to the upside and to the downside. These rapid swings to the downside trigger fear selling and many times cause people to miss some of the biggest up days which tend to follow. To put it in perspective, an investment in the S & P 500 Index from the end of 1987 through the end of 2007 (approximately 5000 trading days) would have returned 11.82% (excluding the effect of dividends). But missing just the best 10 days in this 20-year period would have reduced that average annual return to 9.35%. Moreover, if you had missed the top 100 days in this period, your return would be negative. A key element to surviving a down market is staying committed to a sensible plan one that makes sense given your investment goals, time horizon and risk tolerance. With the recent volatile gyrations in the market many investors have fallen pray to emotions and have let their long-term plans fall by the wayside. It is essential to stick to your plan and not allow you emotions to control your decision making. No one ever made money panicking, cooler heads will prevail. _______________________________________________________________________ The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment may be appropriate for you, consult your financial advisor. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. John Petrick is a Registered Representative with and Securities offered through LPL Financial. Member FINRA/SIPC. He can be reached at 310-445-2504 or emailed at john.petrick@lpl.com. Permalink         Comments (0)

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