Certain Uncertainties and the Market Multiple

Despite a very somber tone in the markets and a temptation to yield to panic and hide under the table, I am trying to maintain a healthy perspective. There are clearly plenty of concerns, negatives, and uncertainties in the market right now.

The market, being a continuous discounting mechanism, is making adjustments to account for new or elevated uncertainty. This is especially true of the extended and nervous markets, in which we seem to be now.

The past five trading sessions were brutal, but the lack of stampede tells me that my gut is right and we are in a corrective phase, rather than a new leg of a bear market. I am sticking to a technical definition of a bear market, i.e. a decline of 20%+. I just don’t think it is in the cards right now. Many investors have been expecting some type of correction in the first quarter, although personally, I thought it may come a few weeks later, at the end February. Well, we are getting it now and I am fine with it, although it’s never a lot of fun if you are net long.

There are clearly a lot of uncertainties in the market now and a lot of noise that will go away. We need to really understand what the market is adjusting for now, what has ALREADY been adjusted for and what is still to come.

I am not very bullish right now, more like neutral, trying to swim with the current, not against it. I am also not ready to come ashore. Basically, I am just trying not to panic and respond emotionally to Obama's lashing out politics. My take is that we are clearly marking US equities down to adjust for additional political risk. That’s right folks, a discount usually reserved for emerging markets with unstable governments, is now being attached to the US equities. I expect that we may correct roughly 8-10%, possibly a touch more on the SPX before we stabilize. My worst case scenario is 975.

Let’s take a quick look to see what are the key things investors are fretting about at the moment:

1) Political risk of Obama's anti-business policies - Obamacare, Volcker Rule, Cap and Trade, etc. Who will he go after next?
2) Potential China slowdown due to credit crunch and changes in lending guidelines, etc. Will it impact the US and European commodities producers and industrial exporters? How much will it subtract from the global growth?
3) Possibility of Bernake/Geithner resignations - funny that we even have to worry about it, but as the saying goes "The devil you know...".
4) Expectations of higher interest rates down the road (either because the Fed raises rates or due to higher yields demanded by the bondholders).
5) Negative Macro - fiscal irresponsibility of our government, unstoppable printing of $$$, widening record deficit, struggling housing, double digit unemployment, weak consumer spending, etc, etc.
6) Struggling US dollar - If it strengthens will it kill commodities and cause massive unwinding of a carry trade, negate the favorable currency winds we had for over a year for US multinationals and diminish their competitive cost advantage? If it stays weak will the Fed raise rates to provide some support to the falling currency?
7) What happens when the fiscal stimulus and other initiatives are pulled?
8) Geopolitical concerns - too many to name..Iran, Iraq, Afghanistan, Pakistan...you all read newspapers.

Despite these very valid concerns (not an exhaustive list by any means, but I don't want to make this post any longer than it already is!) the earnings thus far are looking fine and at the end of the day, earnings and earnings growth are the key variables that influences stock prices over a long term. So with E ok, we are really taking a machete to the multiples...The US equities would need to correct to a more reasonable multiple to account for the uncertainties mentioned above. Some of them are temporary and some have already been discounted. At 1150, the SP was trading at ~15.3x 2010E. Currently we are down ~5.5% from 52 week high. At the next support ~1070, we will be roughly at 14.2x or a full 1x multiple adjustment. My worst case scenario assumes 975 on SP, a 15% move down from the high, resulting in a 13x multiple. I think a full 2x adjustment to the multiple, without corresponding erosion in earnings, should make this market valuation attractive again. Of course, if Obama has his way he will not only destroy the multiples, but the confidence of business leaders, and capital investment necessary to sustain this feeble economic recovery.

Back to the market action. We seemed to have bounced from the early morning selloff after the benign message from the FOMC and good news from Apple about the launch of Ipad. Looks like the buyers are dipping the toes back in the water, very slowly. But I would not be surprised if the declines continue tomorrow. Getting this correction out the way early and having it run its course, will also provide a necessary sentiment adjustment which could bring new money still sitting in the low yielding CD's, bank accounts, or overvalued bond funds.

So - don't panic, you will never make money trading emotionally and following the heard. If uncomfortable with this volatility, take some risk off by reducing portfolio beta, diversify into bluer chips, away from some of the spec stocks where you don’t have a lot of conviction, and wait it out. But my advice is - stay in the game. I am.