So, When's The Bottom This Time?

Phew! First the dot-com then the housing bubble. It's been quite a decade, and there is still a whole year left to go!

Take a look at the S&P 500 index since 1990:

Looks like two eerily similar boom and bust periods doesn't it? However, if we dig a little deeper, we'll see that things aren't at all the same, and the market was actually behaving much more rationally for the second bull run compared to during the dot-com bubble. This gives us some useful clues on figuring out when the bottom of this crash will occur.

Let's first consider what happened with earnings over that time. Here is the same index overlaid with aggregate S&P 500 quarterly earnings data:

Notice how price growth in general follows earnings growth. There are distinct periods of earnings growth (1994-2000 and 2003-2007), followed by very abrupt drops (2000-to-2003, and 2007-to-who knows when). Also notice how stock prices grew much faster than earnings from 1997-2000 compared to the 2003-2007 bull run. This shows that investors were much more speculative (or exuberant) in the late 90's than more recently.

We can make the difference easier to see by plotting the earnings data over the extrapolated P/E ratio:

The extrapolated P/E is computed by dividing the closing price for that quarter over 4 times the quarterly EPS. It's a crude and noisy measure, but a simple gauge of what buyer expectations are at that moment.

You'll notice that there are 4 distinct periods of fairly constant P/E ratios (marked by black bars in the chart above). In the earlier dot-com bull run, P/Es hovered around 18 from 1996-1997, then shot up to the 28 range from 1998-2000.

In contrast, P/Es were around 20 in 2003, and went down to below 17 from 2005-2007.

This indicates that buyer sentiment was far more bearish during the most recent bull run. How much more bearish? Well, a P/E of 28 is 65% higher than a P/E of 17, which indicates that investors were expecting at least 65% greater returns from future earnings in the dot-com days.

Earnings Yield

Let's look at this from another perspective. If we invert the P/E, we get earnings/price, or the earnings yield. Think of it this way: If you were to buy an entire company outright, the return in profit for your investment that you would get after tax at the end of the year would be the earnings yield.

Here's the same chart as above, but showing earning yields instead of P/E:

The data is the same, but this view is easier for us to relate to. For example, during the 1998-2000 period, the earnings yield of the S&P 500 was around 3.6% (100/28). To put that number in perspective, you could have instead put your money in a CD for a guaranteed 5.5% return during that time. So on average, investors were choosing to lose money by buying stocks, in anticipation that future earnings growth (and further speculation) would drive prices up.

In contrast, the average (extrapolated) earnings yield of the S&P 500 was between 5% and 6% during 2003-2007. This was also during a time when saving interest rates were at record lows (under 3% until 2005, then under 5.5% through 2007).

This shows that, in contrast to the dot-com boom which was fueled by speculation, the recent bull run was actually largely governed by fundamentals - meaning that stock market investors behaved fairly soberly and rationally (well, it could be that all the irrationally exuberant speculators just shifted their attention to the housing boom during that time!).

The Bond Floor

Looking at corporate bond yields gives us another strong indication that the stock market has largely returned to fundamental valuation.

First some quick background:

There are two main ways large corporations can raise large sums of money: by selling stocks or selling bonds. A bond is pretty much an IOU to pay a certain interest rate over a period of time followed by returning your money for the bond. It's like the company taking a loan from the public market, at a fixed interest rate that's determined by the market.

Now, think about the relationship of earnings yield to bond yields for a moment: If you are the CEO and need to raise money for expansion, you can either sell stocks (which is selling a share of all future profits) or sell bonds (which has a fixed interest rate). Everything else being equal, you would rationally sell whichever has the lower yield.

Moreover, if bond yields drop below earnings yields (or earnings yields rise sufficiently), companies can (and do) borrow money to by back stock - thus lowering the earnings yield until the two equalize. This effect causes bond yields to be a ceiling on earnings yields - and a floor on P/Es.

Just like individuals, companies have credit ratings. Companies such as Moody's and Standard and Poors (S&P) rate the bond issues of companies from AAA (the best, or "prime") all the way down to D ("in default"). A BAA rating is the lowest "investment grade" rating. So the range of yields for companies rated AAA to BAA should generally represent the yields companies in the S&P 500 would have to pay to raise money through bonds.

If we plot the S&P 500 earnings yield chart over a chart of corporate bond yields, this is what it looks like:

Notice that the earnings yield has been below bond yields all the way up to 2003 (in fact, they have been below AAA bond yields since the early 1980s). This means that during that period, other factors (such as speculation) were the primary factors that drove stock prices. However, starting in 2003 and before the crash in 2007, the average S&P 500 earning yield has hovered around the comparative bond yields.

Let's zoom in on that 2004-2008 period to make it more clear:

In effect, bond yields provided a solid floor for stock prices during that time, and were what pushed prices up (or kept them from dropping).

We can also look directly at the stock buyback levels during that time to see the magnitude of their effect. Between 2004 and mid-2007, buybacks increased four-fold, only dropping off after earning yields declined:

Between April 2003 and September 2007 (which was before the market peak), S&P 500 companies bought back a total of $1.5 trillion of stock. Over that same period, the total market cap of the S&P 500 grew by $5.6 trillion, so the buy-backs contributed (very) roughly 28% to the total gain in price over that time. Without them, prices would have been roughly 28% lower (and earnings yields 28% higher) than they were.

Here's a visual of what the index performance would have looked like if we were to remove the investments due to buybacks:

This great article from S&P goes into more depth on buybacks. Of course, there were many other factors at play during this time, but this clearly shows the powerful effect of bond yields on the market.

Money Exit Stage Left: Enter The Credit Crisis

With this in mind, it's easier to understand what's happening during the credit crunch and what the Fed is fundamentally worried about. Look at what happened to bond yields since September 2008:

When the credit crisis hit, there was a sudden shortage of money available to lend and so borrowers, particularly the relatively less credit-worthy, were forced to pay higher rates. The effect on the stock market was that the floor was suddenly dropped from under it, causing prices to crash.

This is primarily why the Fed took such drastic action, including dropping short-term treasury rates down to zero (yes, they are essentially lending money for free) in order to lower downstream lending rates. This is what caused the subsequent drop in bond yields, although you will note that they are still 1-1.5% higher than where they were at the beginning of the year.

So What Does This All Mean?

While there are plenty of other factors at play (a changing U.S. political administration, a continuing global recession, and ever-present global uncertainty), this is what I interpret this data to mean:

1. A lot of speculation had been "wrung" out of the market from the dot.com crash, which shows that overall investor sentiment has been neutral-to-negative on stocks since 2003, which unlikely to improve in the near term.
2. The Fed is aggressively doing everything they can to pull down interest rates, and eventually they will, causing bond yields to fall back to where they were.
3. When that happens, stock earning yields will equalize with bond yields again, and will rise as earnings rise out of the recession.

If you use S&P's current estimate for Q4 2009 earnings, the average earnings yield at today's prices will be 4.4%. This is already close to the AAA bond yield of 4.75%, but still a long way from the BAA yield of 8.12%. Assuming the Fed's actions manage to bring the BAA yield back down to 6.5% where it was before the recession, by S&P's own estimates, prices could still have a ways to drop (to get the earnings yield to go from 4.4% to 6.5% with constant earnings will require a price drop of 32%).

The thing to keep in mind though is that we have been talking about averages - using a single number to represent the entire market. In reality of course, there is a very wide band of earnings yields across all the companies in the S&P 500. For strong (AAA rated) companies with earnings yields above 4.75% (below a P/E of 21), they should already be at their floor price now. Likewise, BAA rated companies below a P/E of 12.3 should be close to their floor.

Ok, So What Should A Savvy Investor Do?

Keep a close eye on corporate bond yields over the next few months. If they keep their current levels or continue to go down, then it means the Fed is doing their job and credit is flowing back into the markets. That's a sign that the bottom is near (assuming earnings stay on track or better).

Even easier, keep an eye on this blog for updates on how all this plays out.

Happy New Year 2009!

A Look at Unemployment

Here's a chart of the historical unemployment rate from FRED (the Federal Reserve Economic Data service):

Two observations:

First, the absolute best time to be entering the labor force in the last 40 years was right before 2000, when the unemployment rate hit a low of 3.8% in April of that year.

Second, the unemployment rate increased between 2 to 4 percent during each of the recession periods in the graph, with the current increase at already 2.3% since March of 2007.