MARKET INSIGHT
That Market Bottom Might Be a Trap Door
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By KENNETH N. GILPIN
As almost anyone with a market memory can attest, the month of October is
not usually friendly for stocks. Since 1915, the Dow Jones industrial
average has fallen an average 0.17 percent in the 10th month of the year,
according to Birinyi & Associates. Only Septembers have been worse.
This year, September was a washout. But with one week to go, October has
proved to be the best month since January 1987. The performance has been
enough to induce hibernation in many bears.
Then there is James Grant, editor of Grant's Interest Rate Observer.
Q. Many people seem to think the stock market has seen its lows. You don't
agree?
A. If this were the bottom, it would be the most remarkable one in history,
one where the Standard & Poor's 500 index is trading at 25 times earnings.
That is a valuation rarely achieved at the top of a market.
I think that this is a bear market rally. I would suppose that if the market
gods were designing a bear market rally, they would make it look as
irresistible as possible and would want as many participants as possible
before opening the trap door.
Q. But there are hundreds of stocks, especially small caps, that are down 25
percent or more this year. Are they overpriced?
A. Really cheap stocks are beginning to appear. The great, overarching
question is whether you are well advised to seize values in the secondary
and tertiary parts of the market when the primary market is selling at these
multiples.
In my view, the answer is no, because when the GEs, the Charles Schwabs and
the other chosen fall, they will crush the smaller ones beneath them.
Q. Do you see value anywhere?
A. I have two favorite things: small-cap Japanese stocks and gold. There are
opportunities in Japan to buy profitable companies at little more than the
net cash on their balance sheets. You get the business for free. Gold, now
at an 18-year low, has disappointed more people than the old Brooklyn
Dodgers. But I think it will be the beneficiary of continued chaos in the
credit markets and a worldwide economic slowdown.
Q. Do you see anything of value closer to home? Or a company that is a
massive, screaming short?
A. I see both, actually.
In Canada, there is an outfit called Legacy Hotels, which is a real estate
investment trust with a bunch of lovely properties spun out by the real
estate division of Canadian Pacific. You can buy this stock for about half
of book value, with a yield in the low teens, an outfit with good management
that is priced in Canadian dollars, which are very cheap relative to the
U.S. dollar. The risk is that there is a severe recession and the business
travelers stay home.
Q. What about the screaming short?
A. The short sale is Charles Schwab, a stock that is trading at 38 to 40
times earnings, 10 times book value. Schwab is priced as if there were no
doubt about the continued health and prosperity of the bull market.
Q. Now that the Fed has cut interest rates twice in a matter of weeks, fears
of a credit crunch and recession have diminished. Is that an appropriate
reaction?
A. The credit crisis may sound melodramatic, but over the last several
months there has been a very severe bear market in credit of all kinds. And
it should be seen in the context of the preceding bull market in credit,
where it was freely, if not almost promiscuously, available.
There is no recession we know of right now, and yet we have had a credit
crisis in this country, which in the postwar period is a rare if not unique
occurrence. It makes you wonder what will happen to this institution of
borrowing and lending if there is an actual deflation, or an actual
recession.
Q. But isn't it the Fed's job to take steps to prevent a credit crunch?
A. It has been the suppression of cycles that paradoxically has created a
lot of the volatility we have seen in the credit markets. By succeeding in
perpetuating the expansion, the Fed has failed in the sense that it has
changed the behavior of people with money.
By saving Mexico a couple of years ago, the authorities changed the way
people view sovereign credit risk. Hence the surprise when the Russian
government defaulted. A visitor from Mars would not have been surprised that
a country without money could not pay its bills. But many were surprised,
because they had come to expect that the integrity of the system will be
defended.
By suppressing the volatility of the credit and business cycle, by trying to
head off price inflations and deflations, the Fed has thrown a boomerang in
the air, which is the risk tolerance of people who invest money.
The Fed ought to be in the business of central banking, not central
planning. Alan Greenspan ought to say that people who risk money stand to
lose a lot of it. That is in the nature of cycles and markets. |
