Hello Snowshoe, got out of bed for a peek at the DJIA, and noticed it is on its way to target <<Dow: 3,000>>
dailyreckoning.com
"No matter what the Fed model says, eight times earnings today would put the Dow near 3,600"
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DOW 3600
by Bill Bonner Monday, 7 October 2002
Markets make fools of us all - sooner or later. Trying to outsmart them, we say things we will later regret.
"We will not have any more crashes in our time," wrote the world's foremost economist, John Maynard Keynes, in 1927.
"This crash is not going to have much effect on business," wrote Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago two years later.
They might have been right. But, then, who would have remembered?
James K. Glassman found a memorable title for his 1999 book, "Dow 36,000." Now, he tells us that the book "was not so much a prediction as an explanation of how stocks should be priced - and whether for the long term, they are undervalued or overvalued."
If stocks were undervalued in 1999 imagine how much more undervalued they are now. We appreciate the earnest optimism that Glassman brings to stock-market guessing. He believes you can run a few numbers through your calculator and figure out where stocks ought to be priced. And now, even though the Dow is more than 28,000 points below his target and headed in the opposite direction, he thinks we might still be interested in how he thinks stocks should be valued.
Glassman refers readers of his International Herald Tribune column to a formula on Ed Yardeni's website that "allows you to plug in estimates of S&P earnings and interest rates. Based on consensus earning projections, Yardeni on Sept. 25 found the market undervalued by 45%."
A 45% increase does not get you anywhere near to 36,000, but even the longest journey, as the Chinese say, must begin with a single step.
Instead, Yardeni and Glassman stumble. Their formula is based on the 'Fed Model,' it turns out, which compares the yield on 10-year treasury notes to with the earnings yield (for the year ahead) on the S&P 500. The consensus earnings estimates put the yield on the S&P 500 way out in front of the yield on a 10-year T-bond, so when Glassman punches the numbers into the Fed model formula he gets a little giddy. According to these numbers stocks are more undervalued than at any time since 1979! Maybe even before '79 - his chart goes back no further. For all we know stocks may be more undervalued than at any time in the history of mankind.
"I would never try to bully or cajole any fearful investor into the market," writes Glassman, "But history and reason are firmly on the side of stocks for the long run. "
"History shows that this could be just the right time to reconsider stocks," says his headline.
A man who argues that he has God or History on his side should look around him. God and History will decide for themselves, and often end up on the other team.
We don't know, of course. Maybe Glassman has guessed right about the direction of stock prices. All we know is that the Fed Model is absurd. First, the 'consensus' for earnings is the same confederacy of dunces that saw neither recession nor bear market coming...and now says it has been struck dumb by this 'baffling economy' and cannot find words to describe it.
We offered a few simple words last week...this week, we add a familiar observation: that when what goes up comes down it comes down to about where it was when it went up.
Even if they got their numbers right, the idea that stock prices are determined by the bond yields is, as Andrew Smithers put it, "supreme nonsense."
When the yield on the 10-year note goes down, says the formula, stocks are worth more. But what makes treasury yields go down? Well, the Fed can drag them down. Or the market can push them down. In neither case is it necessarily a good omen for corporate earnings or stock prices.
Imagine that the Fed could drag rates down further... desperately trying to avoid a deflationary "liquidity trap." Imagine that it has the same effect as Japan's zero rate strategy. Now, try to imagine how this would make stocks more valuable. You might just as well imagine putting Tom Daschle at the head of GE; the stock price would be no more likely to go up.
Or, imagine rates falling further of their own weight. When business goes bad and consumers feel threatened, they typically stop borrowing, cut costs and begin saving. We have no formula to prove this point; it is just something we've noticed. As people stop expecting to get something for nothing, the demand for nothing goes down...and with it, the price of credit. The economy goes into a slump, interest rates fall, and yields drop. According to the Fed model, stocks should be suddenly more valuable. But then, according to Glassman, the Dow should be at 36,000 too...
In a boom, falling rates give stocks a boost. People are eager to borrow, spend and invest. Lower rates make it easier to do so. But in a real bust, you can lower rates all you want. It is like offering a box of chocolates to your mistress, after commenting that she might need to lose weight; it's too late. The damage has already been done. It is time for regrets.
If what goes up later comes down to where it began, investors who stick with stocks will have many more regrets before the bottom is reached. In 1982, when the great bull market began, the idea that stocks might go to 36,000 was even more preposterous than it is now. The Dow was under 1,000 and traded at only 8 times earnings.
No matter what the Fed model says, eight times earnings today would put the Dow near 3,600.
Yours truly,
Bill Bonner
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