As a warning to the reader, my attendance at a Metallica concert a few days ago may be contributing to the extreme angst I am feeling. The concert, by the way, was really great, especially for my son and his friends. While some of the lyrics are down-right depressing ("waiting for the day that never comes", "growing darkness taking dawn"), truthfully, I couldn't really hear them.
I feel like the guy who had the winning lottery ticket but lost it. I was as bearish as one could be late last year and early this year, but I succumbed way too early to the bottom-guessing game. Despite the horrific market, I was doing alright through the end of September. October and November, however, have spared very few stocks: Nowhere to hide. So I was right, then I was wrong. Being wrong is o.k., but staying wrong isn't, so I am struggling with how to look forward in an environment that appears to be very different than any of us has ever experienced. It is extremely important that we separate our emotions from logic at times like this and not try to find some pattern from past history to attempt to address these unique circumstances.
I have seen so many articles discussing whether this economic crisis is going to be as bad as the Great Depression (mainly ones that say no), but very few questioning whether it could be worse. It could. Will it? I don't know, and none of us does, but one can't just assume that it won't. Yes we have a lot of safety nets, but, due to the fact that they are provided by a heavily indebted entity itself, they may not be as secure as one might think. As you might conclude after reading my recent discussion of GM, the problems we face are bigger than our government. Our Financials and many other companies are so leveraged (tons of debt compared to equity) that investors are rapidly beginning to fear that the bondholders are really not likely to get paid in full. This is becoming a self-fulfilling prophecy as investors scramble for cash, eroding asset values in that process. The debt burden exists on all levels - the individual, companies and local, state and federal governments. And beyond our borders.
Stocks are getting pounded for lots of reasons. Many believe the massive decline is a function of an imminent decline in earnings (or loss generation), which is part of the story. Another important part, though, is that stocks are easily sold. One of their greatest attributes, their liquidity, is becoming one of their greatest liabilities. It's not just stocks. Have you seen what is going on in the world of art? Despite the big rally Friday, gold, the traditional safe haven, has been in decline. Almost every single commodity is in free-fall a well. Commercial Real Estate is in a hard to document crash due to the lack of transactions, but the evidence is clear in the decapitation of the CMBS market and the incredible erosion in REIT valuations.
None of this is news, and one can easily dismiss these observations as being "priced in", perhaps even "overpriced in". I am not short and hope that I am wrong, but I think that this march towards zero will continue for quite some time. I would like to see the market move from such an oversold position so that I could incorporate my views into my own investment strategy and feel more confident about the odds, but that seems to be a universal hope. A client of mine suggested that it is "too late to sell", but is it?
For stocks not to get worse, something has to break the downward spiral of deflation. At the individual level, consumers are in a real jam in aggregate. As unemployment increases, disposable income will go down. As credit continues to contract and as individuals begin to start or to increase their rate of savings and pay down debt, consumption will continue to go down. This process is rather new, and one should not expect that years and years of overconsumption can be quickly fixed. In turn, this puts pressure on government (lower sales tax, income tax, property tax) and on the corporation. Corporations are moving to conserve cash. Ones with challenged balance sheets will need to sell equity to meet future debt obligations, as they can't count on earnings. Other companies have begun to suspend share repurchases (not all, but several), and I expect that more will do so. Yes, falling prices should induce more repurchases, but not in a deflating economy. Why not keep that cash to acquire one's stock or that of another company later? Dividends are being and will continue to be sliced. The cycle is vicious and will take a lot of time to resolve. We have moved WAY beyond this being a housing problem.
With credit contracting for individuals, stocks lose their appeal as an investment. With diminished credit, one has to have CASH to pay for automobiles, college education or other big ticket items. This year we learned that even "cash" is not cash (the auction rate securities). Bonds, too, are rapidly losing their allure as credit deteriorates. As the crisis deepens, we should expect to see significant defaults in the municipal market. With T-Bills essentially yielding essentially zero, clearly cash is already at a premium. The government has had to increase the protections for other types of cash, like bank deposits or even money-market funds. Can it back-stop all investments?
Looking at corporate balance sheets and valuations, one would think that there is absolutely no connection any longer. Why are so many smaller companies trading at significant discounts to their tangible equity? What is the market saying? Traditionally, there have been investors, whether mutual funds or private equity investors that would buy these companies trading at such deep value. I am not talking about microcaps - but rather companies with significant brand value like Foot Locker (FL), Williams-Sonoma (WSM) or Timberland (TBL). Where is Warren? Oh yeah, buried in GS and GE. With so many smaller companies dropping towards or below tangible book value, is it unreasonable to assume that the market ultimately can't "afford" to support larger companies at this type of valuation? I believe that part of the reason is that investors are beginning to realize that assets carry hidden liabilities. Falling prices mean inventory is worth less. Rising debt defaults means receivables aren't as collectable. Falling values also means property, plant and equipment might not be worth as much as the balance sheet implies. The debt is the debt, but the assets aren't really what they appear.
Looking at some of the largest companies, I am worried about the downside if they trend towards tangible book value. First, many of these companies have been acquisitive over the years and have a lot of goodwill and intangibles, which makes that "real" equity number even lower. Second, the premiums are still pretty high:
These are all of the S&P 500 companies with market cap in excess of $50 billion, ranked by market cap. These 28 companies make up 43% of the value of the S&P 500. I included a column called "leverage", which is Assets divided by Equity. The higher that ratio, the more obligations or liabilities the company has. I would expect that high leverage and a high valuation relative to tangible book would suggest challenges ahead. The median valuation is almost 4X (and 3X book value), while the presence of several companies with negative tangible equity reduces the average significantly. If we are in for a period of falling tangible equity (losses) and difficulty repaying debt due to a lack of capital, clearly these companies could fall significantly.
The government will be trying to extinguish fires on multiple fronts for some time. There are so many companies that are "too big to fail" that the government will be expending significant resources restructuring these entities. Next, it will be propping up municipalites and states, who will experience falling sales tax and be fighting with consumers over property taxes. Then, the consumer himself will be counting on the benevolent uncle in so many ways: Fix my mortgage, pay me unemployment benefits, give me a tax break. All of this adds up potentially to federal debt like we have never seen before. I expect to see a massive transfer of wealth from the wealthy to the indebted via either inflation or confiscatory wealth taxes. Yes, ultimately, our government may choose to tax savings or assets (property taxes) in order to encourage spending. In an environment of high taxes, inflation and possibly even wealth taxes, stocks could be a very dangerous place to be.
As I said before, I hope I am wrong. I have tried to remove the emotion from the argument and to extrapolate the current facts as I understand them. If you are bullish, I think you need to have a good answer to the following question: Who will buy the stocks and why will they part with cash to do so? Why buy a stock, when you can buy debt at such a steep discount? Debt is rapidly becoming the "new equity", with significant price appreciation potential. I certainly can see a big rally in the near-term, maybe even over the balance of the year. One contributing factor could be reallocation by pension funds, who have seen their equity exposures drop as a percentage of their overall holdings. Absent that dynamic, the market is moving away from the long-successful mantra of "buy the dip" to "sell any rally". One of my clients is "averaging out" of the market, and I can't blame him. Yes, it can get worse.
Disclosure: Long CSCO and TBL, and CVX, CSCO and TBL are members of one or more of my model portfolios