Why Perma-Bears Are Coming Out Of Hibernation

Well, aren't you glad October 2008 is over? After all, the 17% drop in the market was the worst month in 21 years (Crash of 1987). Given the tremendous drop in stock prices, we are beginning to read about many perma-bears who have turned bullish, which is quite a good sign for investors (this week's Barron's includes an interview with Steve Leuthold of Leuthold Group, another so-called perma-bear who is bullish on stocks).

First, what is a perma-bear? The nickname has been given to investment strategists and managers who seem to be permanently bearish. Why do they rarely sing the praises of the stock market's prospects? Did they have a bad experience and simply have yet to get over it? Hardly.

Actually, perma-bears do turn bullish every so often, it just takes a lot for that to happen. The reason is because perma-bears typically only want to invest heavily in stocks when prices are extremely cheap, typically in bear markets. You see, outsized market returns are attained the easiest when prices are depressed, so perma-bears are more than willing to forgo owning stocks in size until prices are dirt cheap. As a result, they are not bullish very often because bull markets last far longer than bear markets and economic expansions last far longer than recessions.

Since investing when stocks are dirt cheap is a proven winning strategy, why do perma-bears get so much heat? Well, the simple explanation is because since the first stock market opened for trading, in any given year stocks have risen about 80% of the time. So, if four years out of every five are going to see stock prices go up in value, perma-bear detractors would argue that only investing during the depths of bear markets, while a profitable strategy, misses out on many years of market gains.

Fair criticism? Sure, but it depends on your viewpoint. Proponents of long term investing would argue that one would be better off not trying to time the market and accept that during any five year period, they expect to make money during four years and lose money during one. Statistics have shown that strategy pays off handsomely over the long term.

Perma-bears are a little more difficult to please. They realize that the average bear market results in a 30% loss, and such a hit requires a 43% rise just to get back to where they were before the drop, so they prefer to try and avoid such a painful decline, despite it being temporary in nature. By only investing when stocks are dirt cheap, they are able to reduce the chances they incur sizable losses. As a result, the perma-bears missed much of the last bull market (stocks rose for four straight years heading into 2008, just as market history would have predicted).

So, what should we conclude when the worst month for stocks in 21 years has resulted in several well-known perma-bears coming out of hibernation and recommending investors buy stocks? It means that for the first time in a long time, stocks are at the low end of their historical valuation range, which usually equates to an excellent buying opportunity. The perma-bears are getting another opportunity to come out of hibernation and play, which bodes well for all of us.

Watch the 2002, 2008 Intra-Day S&P 500 Lows

The forced selling and mass liquidations are continuing, with the pre-market futures trading limit down this morning. October has always been the most volatile month of the year, and investment fund fiscal years end a week from today (as opposed to a normal December year-end).

Don't fool yourself into thinking the market action here is based on fundamentals, because everything we are seeing is simply irrational behavior based on forced selling. Buyers are balking because once things become irrational, there is no inherent floor to prices.

If you want to watch specific levels, the 2002 S&P 500 low was 768. The 2008 low so far was 839. The S&P 500 closed at 908 yesterday, and traded limit down (60 points) to 855 this morning. If we don't hold those levels, another round of computerized sell programs will likely hit the market. The support there should be strong, but in this market, who knows what will happen.

Update: 10:00am -- Here is a graphical representation of the last two decades:

Analysts Still Nuts With Their 2009 Earnings Projections

One of the reasons sell-side analysts on Wall Street are usually pretty bad at picking stocks is because they are reactionary, not anticipatory. Remember, the market is forward-looking, so what already happened is irrelevant.

Here we are, in a recession, and by most accounts the economy will stay bad well into 2009. And yet, the consensus estimate for 2009 S&P 500 operating earnings stood at $100.90 as of 10/14. That compares with a 2008 estimate of $75.94, which means the sell-side is projecting earnings growth next year of 33%. Absolutely nuts, right?

The problem is that analysts won't ratchet down their numbers until the companies actually come out and give specific 2009 guidance (they wait to be spoon-fed it, rather than anticipating it ahead of time like the market does). In such an uncertain economic environment, firms are uneasy about projecting earnings for this quarter, let alone next year. As a result, we have everyone on Wall Street well aware that 2009 earnings for the S&P 500 will be nowhere near $101 (hence the market has tanked), except the analysts won't tweak their official forecasts ahead of time.

Look, how long the bear market lasts will likely depend on how long the economy stays weak, but how far the market ultimately falls during the bear market will depend, in large part, to how far earnings fall. As you can see below, S&P 500 operating earnings peaked way back in 2006 before oil prices spiked and hurt many companies who have oil as a major input cost.

S&P 500 Operating Earnings:
2005A: $76.45
2006A: $87.72
2007A: $82.54
2008E: $75.94
2009E: $100.90

Obviously the 2009 number is crazy, but how far will earnings drop? The headwind is the recession we are facing, but with that we are seeing commodity prices come crashing down. That will help profit margins at most companies because their expenses will drop alongside their revenues.

Even if we see a recession during most of 2009, earnings might hold up better than some pessimists think. If that is the case, it should put a floor under stock prices next year, even if we hover along that floor for a while. So, the thing to watch is not whether $101 of S&P 500 earnings is doable in 2009 (it isn't), but rather if we can manage $70 to $75, which would make some of the more dire predictions of $50 or $60 overly pessimistic.

Warren Buffett Op-Ed Explains Why He Is Buying, Not Selling

Warren Buffett's Op-Ed in the New York Times today is a must read. He echoes many of the same thoughts I offered in my quarterly letter to clients last week, but don't take it from me, the Oracle of Omaha feels the same way.

You can read the full piece here

Some highlights:

In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So... I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

I haven't the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: "skate to where the puck is going to be, not to where it has been."

Strong Balance Sheets Make Hunting For Value Easier

During the last bear market (2000-2002) there were dozens of situations where individual stock valuations looked down right silly. This bear market will be no different, and long term value-oriented investors can take advantage of the fact that in times like these numerous bargains can be had, but most people are too afraid to take them.

A great way to find value in the market is to use enterprise values (market values after netting out the firm's cash on hand and debt outstanding). Investing in companies with hoards of cash in the bank allow investors to get the operating businesses on the cheap. There are many examples of this, and I often talk about net cash positions of various stocks on this blog, but let's use former Halliburton (HAL) subsidiary KBR (KBR) to show what I am talking about. I don't own the shares, but it fits the description perfectly.

At $15 per share, KBR stock is down 66% from its 52-week high of $44 and sports a market value of about $2.55 billion. Earnings in 2007 were $1.08 per share, and are expected to jump to $1.72 this year and $1.98 in 2009. That quick glance shows that KBR appears to be a pretty cheap stock at about 10 times trailing earnings and less than 9 times current year projections, but KBR's balance sheet tells an even better story.

As of June 30th, KBR had cash on hand of $1.85 billion and no debt outstanding. With a market value of only $2.55 billion, KBR's enterprise value is merely $700 million. With $11 per share of net cash in the bank, investors who buy KBR at $15 per share are getting the firm's operating businesses for the aforementioned $700 million, or only $4 per share. This for a company that has earned $428 million in operating income in the last 12 months.

A valuation of less than 2 times cash flow is truly silly, but in markets like the one we have right now, nobody really cares because they are too busy being concerned about overnight LIBOR rates and when the Treasury is going to start buying up assets from banks. What great news for long term investors who can seize on opportunities.

Full Disclosure: No positions in the companies mentioned at the time of writing, but positions may change at any time

Don't Borrow Money to Buy Stocks

Much of the recent market decline has been due to forced sellers like hedge fund and mutual fund managers that have had no choice but to sell stocks they own due to redemption notices from their panicked investors. In many cases, forced selling has also taken the form of margin calls.

Consider the shares of long time Peridot favorite Chesapeake Energy (CHK) which fell 50% in just the last 3 days of last week. The stock movement felt like panic selling and late Friday we learned that the company's largest shareholder (the co-founder and CEO) was forced to sell most of his 5% stake in the company between Wednesday and Friday. Why? To meet brokerage margin calls that were triggered because he had bought the shares in part with borrowed money.

For the most part, I would never recommend that individual investors borrow money to buy stocks. Every so often there are arbitrage opportunities that can be completely hedged and therefore using margin can pay off if downside risk can be hedged away, but speculating on a stock price's future movement based on fundamental bullishness (as was the case with CHK) with borrowed money is a recipe for potential disaster.

Aubrey McClendon, Chesapeake's CEO, has paid the ultimate price by being forced to sell 94% of his stake in his own company in the middle of one of the most panicked weeks the market has ever seen. Don't make the same mistake he did by speculating with borrowed money. Leverage has crushed the investment banks, but it can get individuals in deep trouble too.

Full Disclosure: Peridot was long shares of CHK at the time of writing, but positions may change at any time

How Low Can We Go?

There is no right answer, since we have no idea ahead of time, but looking at the biggest S&P 500 declines over the last 35 years can shed some light on what would be typical for a deep decline. Some pretty interesting similarities here. I will update this chart as times goes on.

History Lesson & Bear Market Advice

History tends to repeat itself. The economy and the stock market are no different. We have had, and will continue to have, economic expansions followed by recessions. To give you an idea of what to expect, consider the last recession.

It was the result of another bubble bursting (in Silicon Valley, not housing). In 2 1/2 years (early 2000 through late 2002) the S&P 500 fell by 50.5%. Investors felt massive pain and many took dramatic action by getting out of the market. That was the right emotional decision in their minds at the time (because they didn't want to take any more pain) but it backfired financially.

After a 2 1/2 year bear market, the S&P 500 bottomed in October 2002 and rose by 105.1% over the next 5 years. Those investors who stuck with the market and even added to their investments as prices dropped reaped huge rewards. Those who exited the market out of fear missed out.

With the market down more than 35% in the last year, what should investors do now? For the answer all we need to do is look at history. About 97% of all five year periods have seen the stock market go up, as have nearly 100% of all 10-year periods. If you are a long term investor (5 year time horizon or more by my standards) the numbers imply you should stay in the market.

You may have noticed that Warren Buffett has been very active in the market in recent weeks, investing billions of dollars. Is he crazy? No, he simply knows that when prices drop significantly there are bargains to be had. Future stock price returns are going to be higher during bear markets than bull markets because prices are lower. It isn't any different from buying a house, a car, or a cart of groceries. When things go on sale, we should buy more of them. Have you ever been to the store, seen your favorite cereal on sale, and bought a couple extra boxes than normal because of the price? I know I have.

Stock investing shouldn't be any different than grocery buying. It is true that it all sounds so simple, but isn't because emotions and psychology come into play more with stocks. Warren Buffett has the perfect temperament for the market, so he can step in and buy when everyone else is selling. His famous quote is "be greedy when others are fearful and fearful when others are greedy" and he is acting on that principle through all of this.

It is not an easy thing to do, though. Most people want to get out of stocks right now, not sit tight or buy more. That is what their emotions are telling them to do. Unfortunately, it is not the right decision to make for an investor who has the time to wait things out for several years.

I will conclude with a story. During the first week of October 2002 I wrote a letter and sent it out to about three dozen friends and family members. I explained that the stock market was very depressed but that there were tremendous investment opportunities out there. I made the case that allocating money with Peridot Capital at that time would likely prove very profitable over the coming years.

Guess how many people invested new money with me? None. The responses were predictable, although I had hoped some would take me up on my offer. Many recipients simply ignored the letter completely. Some responded by telling me that they had sworn off the market after they had lost so much. One declined my offer by explaining "As you know, this is not the easiest environment to lure potential investors." Very true, but ironically, it was the perfect time to do so.

A week after I sent out that letter, the S&P 500 index bottomed out at 768.63 on October 10, 2002. Over the next five years the market more than doubled and reached an all-time high of 1,576.09 on October 11, 2007.

So my bear market advice in as few words as possible would be:

1) If you have a 5-10 year investment time horizon, or longer, do not sell your stocks simply because prices have fallen significantly and it is scary to watch the daily market swings and read the dire news headlines.

2) If you have the financial means, and are comfortable doing so, adding to your investments during times like these will most likely prove very profitable as long as you can take a long term view on the investment.

3) Don't pay attention to the daily market volatility and headlines if you don't have to. If you are investing for 5 or 10 years, who cares what the market does today, this week, or this month? It's irrelevant. Warren Buffett often says that he wouldn't care if the market shut down for a few years and reopened because he is confident in the long term prospects of the stocks he owns.

If only we could make that happen in times like these. It would ease the short term pain and also ensure long term gain.

Witnessing History

Can you recall the last time the Dow fell 777 points in a single day? Well, it never has, until today. This post will be brief. I am going to forget about the market and focus instead on the Ravens/Steelers game tonight (I am from Baltimore, but moved to Pittsburgh earlier this year) to try and take my mind off what happened in Congress today. In coming days we will likely see another bill come up for a vote, perhaps better, perhaps worse, than the current one. The Republicans will vote for it and hopefully we can make back much of today's loss in relatively short order. Hopefully people will begin to realize that this kind of bill does far more than pad the wallets of Wall Street (heck, 40% of the big 5 firms have gone belly up already). The banks we all hold our money with are not Wall Street. Rather, they are the lifeblood of Main Street.

Thoughts on the "Bailout"

A reader asks:

"Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?"

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bailout Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers' expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional (typo, corrected and replaced "nominal" with "notional" -CB) value. By doing so, we are converting unrealized losses on the banks' balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn't functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn't want to do that anyway since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don't understand why anything needs to be done or are misguided in their belief that all we are doing is "bailing out Wall Street." The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.