Thursday, August 26, 2010

Double Dip - Is it Likely?

These days, much of what you read is about the economy/stock market going into a double dip.  The fear is justified by recent economic data.  For example, US jobless claims are now at a 9-month high.  Existing home sales are at a 15-year low, and so on.  The main question is then, for investors, will the stock market dip to where it was in March 2009, when S&P 500 dropped to as low as 666 points?

The Economy Versus the Market
I want to highlight an important distinction between a double dip in the economy and a double dip in the stock market.  As much as some would like to believe that the stock market is an accurate reflection of the economy, it is not.  Studies have shown that GDP growth do not correlate to a stock market's performance.  That's strange, isn't it?  Am I saying that when the economy is doing badly, the stock market could rise, or vice versa?  Yes!  But how can that be, you ask?

It's actually quite simple.  The stock market prices are controlled by investor sentiment, and sentiment may not always align itself with reality.  For those of you who have owned stock, you would know what I am talking about.  You've found this amazing company, have studied on it, and made the conclusion that it was a good buy.  You put some money where your mouth is and buy the stock.  In a few weeks, the stock is down 20%.  What do you do?  You sell your shares and take a hit.  You just confirmed what the market thought, that the stock was worth 20% less than when you bought it.  But is it?  Was your decision based on an evaluation of how much the stock was currently worth, or was it affected by your aversion to further loss?

Why the Market Shed More Than 55% of Its Value in 2008-2009
Until I followed my friend Matt's recommendation of reading a book called The Big Short, I really didn't have a good idea of what exactly happened during the great crash of 2008-2009.   I recommend any investor to borrow that book from his closest library and read it from cover to cover.  It opened my eyes to the whole subprime mortgage debacle.  What happened was that Wall Street created a whole bunch of junk bonds, which were backed by subprime mortgages, and sold them to unsuspecting investors, because they were able to get the rating agencies to rate them as AAA (the best rating possible).  When mortgage owners defaulted as housing prices fell, the value of these bonds went pretty much to zero.  This industry was worth a few hundred billion dollars, and you all witnessed what happened when it went bust.

Since many banks were involved and had huge losses, the ones that survived held on to cash and created a credit crisis.  The result was that many companies not affected directly by subprime mortgages now could not borrow money (to run its operations, for example) and everyday investors lost a significant sum of money.  This all contributed to the eventual recession as both groups tightened their belts severely.  If you recall September of 2008 when Lehman Brothers went belly up, all you could really think of was, "Wow, the world is ending before our eyes."  Not only was it Lehman Brothers, there was Merrill Lynch, Citigroup, Morgan Stanley, Fannie Mae, Freddie Mac, AIG, and the list goes on.  Eventually, the crisis spread beyond the financial sector and the first to be hit were inefficient companies like GM and Chrysler.  Seeing all of this, investors pulled all of their funds as quickly as possible.  As a result, stock prices free fell.  In March 2009, S&P 500 hit its bottom when it briefly touched 666 points.

Remember, It's All Sentiment
Maybe it's been a little too long now, but most people seem to have forgotten how apocalyptic things looked back in 2008-2009.  Now, let's see if this whole episode can be replicated.  Is it likely for the stock market to reach 666 points, again?

First, to answer that question, we need to answer the question of what 666 points in the S&P 500 index represented? That low level likely represented market sentiment that priced in a recession that would be similar to the 1930s Great Depression, where 30% of the population was unemployed, where men had to ride on freight trains from city to city to find work, where countless people called the streets their home.  666 points represented a time when all of the companies named above were expected to go out of business, when the American economy was expected to be even worse than Japan's lost decade.

Second, we turn to the latter half of 2009-2010.  We have seen one of the greatest V-shape recoveries of the stock market of all time.  In April and May of 2010, I recall pundits calling it a "bear market rally" or a "dead cat bounce".  What ultimately happened was that the S&P 500 rallied from 666 points all the way up to 1219 in a little over a year.  The US GDP actually expanded at an astonishing rate (see figure below) during that period.

The market may have gotten a little ahead of itself, jumping from depression to euphoria in a few quarters.  To be sure, there are many issues yet to be resolved in the US and global economy.  Unemployment is 10% in the US.  Many European countries have debt problems.  However, will it warrant a double dip of market sentiment to drive the S&P 500 index back down to 666?  As I see it, the market, even at its current levels (1055 pts versus 666 points), do not reflect a very optimistic or exuberant sentiment.  Excellent growth companies that I have frequently mentioned are at very low P/E ratios (e.g. FSLR: 17, TRLG: 11) relative to their expected growth.

In order for the market to dip down to 666 points again, an event of catastrophic proportions must occur.  Exactly how big that event has to be?  I would venture to guess that you would need to see a good number of major corporations on the brink of bankruptcy (recall Lehman Brothers, Citigroup, Fannie Mae, AIG, etc. etc.).  Yes, housing sales are dropping...yes, unemployment is still high...yes, the US population is growing older...yes, the US government has trillions of dollars in debt.  But will we see the same number of companies go belly up?  I do not think so.

What's Next?
I'm no economist (heck, I didn't even take ECO101 in university) and I may be totally off the mark, but history tells us a lot.  The 1970s were a grim period and yet, Warren Buffet was able to make a killing during that time.  Why?  It was not because the economy was doing great, but it was because he picked the right companies in which to invest.

So, even if I were utterly wrong in this post, there are still plenty of ways to be profitable.  In fact, this may be the best time to invest.  Remember Buffet's famous saying, "Be fearful when others are greedy, and greedy when others are fearful."  I'd say there's plenty of fear on the street right now, just like in March 2009.