July 26, 2004


Stocks Keep Falling, But Key P-E Models Say They're Cheap (Ken Hoover, 7/23/04, Investor's Business Daily)

Corporate profits are hitting record highs while the stock market is down for the year. That can mean only one thing: stocks are getting cheaper.

The 12-month trailing P-E ratio for the S&P 500 hit 17.7 on Friday, the lowest since 1996. That's based on S&P's estimate of $16.21 a share for the quarter ending June 30, which is up from a $15.87 preliminary reading for the quarter ending March 31.

The valuation on the S&P 500 isn't a historical low, but it's well below the highs of the bubble years, when it soared above 25. It hit 45 in 2002 as earnings were sinking.

In fact, the S&P's P-E ratio, based on operating earnings, is below the average of 20 going back to 1988, but still above the average of 15.6 going back to 1935.

"It's hard to characterize the market as cheap," said Nick Bohnsack, an analyst for International Strategy and Investment. "We think stocks are fairly priced."

Which is why most of us, who won't be retiring for decades, are wise to just keep buying. Meanwhile, those high profit margins mean businesses can (as they must) absorb temporary inflation blips without raising prices.

Posted by Orrin Judd at July 26, 2004 10:45 AM

In late 2003/early 2004 there was some argument that an improving stock market was more important than improving unemployment numbers for Bush's reelection. The positive feelings from the rising stock market would offset any negative feelings about job losses. Now the reverse seems to be happening - stocks not doing well but employment numbers better. Any new opinions on which will be more important for the election?

Posted by: AWW at July 26, 2004 10:52 AM

They're not likely to diverge for very long are they?

Posted by: oj at July 26, 2004 11:01 AM

OJ, no, but if stay diverged until 11/2/04 it will matter....

Posted by: AWW at July 26, 2004 11:10 AM

Why? With economic news this good for this long the market wouldn't seem to mean much unless it tanked.

Posted by: oj at July 26, 2004 11:19 AM

The media is spinning the economic recovery as bad as possible, a re-run of the campaign against Bush #1. All the new jobs are McJobs, the good jobs are going to India, the deficit is still growing, health costs are still out of control, yadda yadda.

Some investors are letting themselves get spun, helping make the market twitchy despite the fundamentally good growth and job numbers.

Posted by: Gideon at July 26, 2004 11:47 AM

"The 12-month trailing P-E ratio for the S&P 500 hit 17.7 on Friday, the lowest since 1996."

The only problem is that in 1996 the market was going up, now it is going down. Historically, when bear markets bottom out, the PE ratio is somewhere around 6.

"They're not likely to diverge for very long are they?"

OJ, just remember, the market is a leading indicator.

Posted by: Robert Duquette at July 26, 2004 6:30 PM

Except when it isn't.

Posted by: oj at July 26, 2004 6:43 PM

I agree with AWW and Gideon. Bush needs a rising stock market as a counter to the negative spin put on any economic numbers.

For example, the local fishwrapper spent several column inches at the top of the business page a week or so ago explaining the largest month-to-month drop in retail sales in the last 18 months (IIRC). Accompaning the article was a small bar graph that happened to show retail sales back to June, 2003. If you looked past the bold black bar that represented June, 2004 retail sales at the barely-darker-than-newsprint gray bars for the rest of the year, you could see that retail sales have been steadily increasing for the entire year and were still above June, 2003.

Not one word about it in the story, though. Guess they ran out of space.

Posted by: Chris B at July 26, 2004 8:41 PM

Bush has invested too much of his presidency in reviving the economy, so he obviously needs a strong market going into the election. I doubt that he will get it. The winds of falling rates, falling inflation and a strong dollar are no longer at the economy's back. Rising rates, rising inflation and a falling dollar are now headwinds pushing against the economy. Here is a very good explanation of what is going on:

It's amazing to me that I am the only bear on this blog. What's with all the goofy optimism? There are plenty of very credible sources pointing to the weaknesses in this recovery. I forward several to OJ each week, but he won't post such heresy.

Posted by: Robert Duquette at July 26, 2004 9:17 PM

Some tidbits from the WSJ today: foreign investment is declining (both stocks and bonds) and has been for about 5 or 6 months; short selling is ramping up; the seemingly close election will cause uncertainty until Nov.; and the earnings worm is turning downward. Additionally, the news that United is probably going to let its pension plan implode has to hurt (plus, it might mean a $7.5 billion punch to the taxpayer).

Of course, just a few weeks ago, the paper was reporting that all the downsizing and cost-cutting since 2000 had put corporate America in its fittest shape since 1984. And the changes in dividend taxation are certainly paying dividends, one might say.

Posted by: jim hamlen at July 26, 2004 9:22 PM


He didn't take any actions to help this economy, he took long term actions aimed at permanently restructuring the economy.

Posted by: oj at July 26, 2004 9:23 PM

The article you insereted there, for instance, assumes a number of things that appear unlikely--that our population won't keep growing and that younger worjkers won't keep pumping money into stocks. Start to privatize social security and such stock buying obviously explodes.

Posted by: oj at July 26, 2004 9:25 PM

I agree that the averages are not so important, but note that that did not prevent Orrin from crowing not so many weeks ago about a DJIA at 11,000 by November.

Anyhow, an undervalued (or overvalued) market kind of puts a crimp in arguments for letting markets wag the dog, don't they?

Posted by: Harry Eagar at July 26, 2004 9:45 PM

OJ, deficit spending is a short term measure to boost current economic activity at a future cost. It is unsustainable long term.

His long term restructuring, the Medicare prescription drug benefit, will worsen future deficits. Just another entitlement that we cannot afford.

Posted by: Robert Duquette at July 26, 2004 9:45 PM

OJ, our population was growimg much more strongly in the 60s and 70s, and we had sluggish growth. It is a matter of working off market excesses. The equity, bond and real estate markets have gotten way ahead of themselves. There is too much debt and not enough savings (cash, not inflated paper assets or housing values). The economy won't be able to stage sustained, steady growth again until our personal and governmental balance sheets are cleaned up.

You forget that these younger Americans will be paying a much more onerous burden to the Social Security and Medicare/Medicais systems than the Boomers have.

Privatizing social security will not make companies worth more than they are. Too many buyers create bubbles, which don't last for the long term. Bubble wealth isn't real wealth.

Posted by: Robert Duquette at July 26, 2004 9:58 PM

Our population is growing at 3% a year. We have more savings than we know what to do with--even if we paid off evety debt held by every American individual, company, or government we'd have tens of trillions left over. Companies have tons of money on hand because they've been reluctant to use it in such an uncertain period. The stuff we buy costs less every year than it did the year before. The global political situation is uniquely conducive to strong growth. Hard to see how things could possibly be any better. They've certainly never been better in human history.

Posted by: oj at July 26, 2004 11:04 PM

Short term measure? We've been deficit spending for almost a century--when does the long term kick in?

Posted by: oj at July 26, 2004 11:08 PM

How much did a loaf of bread cost in 1920?

Posted by: Robert Duquette at July 26, 2004 11:11 PM

One full day of the average American's wages.

Posted by: oj at July 26, 2004 11:13 PM

What happens if oil goes below $35/b?

Posted by: Sandy P at July 26, 2004 11:14 PM

uncertainty is the order of the day on wall street. it goes horizontal in election years, almost on queue. the fact that it's declining (and yes oj, market is a leading indicator, usually 5-6 months), doesn't bode well for bush, who arguably would be more business friendly than kerry. if kerry or bush slips up and polls start to predict a landslide winner closer to november, look for stock prices to even out and begin their ascent.

Posted by: poormedicalstudent at July 27, 2004 12:27 AM

If the DOW is a leading indicator (by 5 or 6 months), what was it indicating between mid-May and mid-June?


Posted by: djs at July 27, 2004 1:33 AM

Sandy P:

The major industrialized nations celebrate.


Mainly because being a bear, whether of financial markets, American society, or America herself, has been a losing proposition for 300 years now.

You may well be right regarding the possibilities of a downturn in the economy or the stock market, but it has seemed to me that you have a very pessimistic long-term future outlook, one that I cannot agree with.
As oj asks, if not America, then whom ?
The EU will not out-compete the US over the next century.
China might have periods of greatness, but first they have to sort out their political, financial, and demographic messes, which might mean a civil war.
India has the same problems, but to a lesser degree.
Japan... Well, we know about Japan. (Unless, of course, they manage to get some real-life manga battle-bots off the drawing boards).

There just isn't yet any credible replacement for the US' military and economic domination of Earth.

Posted by: Michael Herdegen at July 27, 2004 2:44 AM

In 1920, an average urban day's wage was $1 to $5, depending on skill. Bread was 10 cents a loaf.

Much of the savings Orrin imagines is imaginary. The only way to realize on the 'savings' in our real estate would be for all of us to exchange houses with each other, leaving us exactly where we were before.

There has long been a slogan about that sort of confused economic thinking: 'Men maintained a precarious economic existence by taking in each other's washing.'

Posted by: Harry Eagar at July 27, 2004 3:08 AM

djs: if i were to take a short enough sample size, i could say that the market is a lagging/leading indicator etc. in economics, finance, business-speak, the market has always been looked at as a leading indicator with an average lead-out time of 5-6 months. are there times when it gets into a trading range, sure. the important part is to look @ it over the past 6 months, 12 months, 18 months, 24 months, etc. also, you might want to see when it has tested lows, and when it has broken out. advancers versus decliners, etc. is also good to look at. right now, we're in a trading range that has bordered on anaemia with downward pressure due to uncertainty about 1) the elections, which leads to 2) uncertaint about the economic, domestic, foreign direction of this great country come january.

harry: what's the savings rate in japan? what has it been in japan for the past 20 years? compare that to the savings rate in the US, then compare it to growth rates in the US.

Posted by: poormedicalstudent at July 27, 2004 8:10 AM


Okay, one hour's labor.

Posted by: oj at July 27, 2004 8:19 AM


But the savings, and value, are as real as any other store of wealth.

If we all saved gold coins, and all tried to sell 'em at once, the value of gold would plummet as well, or substitute any other commodity or artifact you like.

However, we don't all try to sell our homes at the same time, which is why people can monetarize their home's appreciation.
That's "savings".

The only form of savings that comes to mind that doesn't require a buyer is the one-year's supply of food that Mormons are advised to keep.
That, one can always eat, regardless of whether anyone else is hungry.

Posted by: Michael Herdegen at July 27, 2004 10:57 AM

In the long term (100 years) I am bullish and optimistic. Over the next 20 years I am not. As I will want to retire in 20 years max, that is my investing horizon.

What troubles me the most is the idea that we have conquered the business cycle. Economies have always grown and contracted in a cyclical manner, it is a constant. Recessions or contractions are good, they work off the excesses and malinvestments of the last boom cycle. The problem is, we have borrowed too much to keep this last boom cycle alive. Rather than go to the dentist to fill a cavity, we have kept the pain away with novacaine, until the cavity gets so bad that we will need a root canal.

The economic numbers look good for now, but you have to understand that this is an economy on stimulants. Like a patient with a bad heart in a hospital, who has been injected with epinephrine, our pulse looks strong. But don't judge the patient's health by the ekg. He can't stay on stimulants forever.

There are fundamental imbalances with our economy that need to be corrected, imbalances that have gotten worse over the last 4 years. They won't go away. The national debt will exact a price. Personal debt will exact a price. The trade deficit will exact a price.

Posted by: Robert Duquette at July 27, 2004 12:44 PM

Michael, these are good points, but you are missing the critical factor with housing "wealth". Housing prices can be overvalued. If housing prices increase faster than increases in the standard of living, due to speculation or to historically low interest rates, you cannot count the increased equity as reliable savings. That increase is subject to the factors which spurred the buying pressure, when those factors are removed, the increase goes away.

Rates are going up. If you bought a house at the top of the market, don't expect that you will get what you paid for it when rates are 3 points higher. If you extracted that equity at the top of the market to pay off your credit cards and buy a boat, you may end up owing the mortgage company more than you can get for your house. It doesn't require everyone selling at the same time for this to happen, housing prices will revert to their true value over time as the excess buying pressure evaporates.

Here's a Business Week article that predicts nationwide housing prices could slip 5% to 10% over the next 5 years.


Posted by: Robert Duquette at July 27, 2004 1:06 PM

Sure, despite no inflation, economic growth and a population boom housing prices will tank. Any day now...


Posted by: oj at July 27, 2004 1:33 PM

I'm with Robert on business cycles.

As for savings, anybody old enough to remember the '60s (which around here means only me) knows that the only place to 'keep' savings is in productive assets.

But,. as W. Edwards Deming used to remind us, technology can devalue productive assets in a hurry. Newspapers used to have millions and millions of dollars 'worth' of Linotype machines.

The Japanese ought to serve as a cautionary tale about the value of 'savings' in real estate.

I think there is confusion in this discussion between liquidity and net savings.

Net savings are not all that valuable in a crunch, as Coolidge ought to have taught us.

Liquidity counts for far more.

Japan has large liquid savings (US bonds). Americans don't.

In an expanding world economy, the US is OK that way. In a contraction, not so hot.

Posted by: Harry Eagar at July 27, 2004 1:43 PM

The Japanese didn't have real estate nor stocks--they had (have) savings accounts.

Posted by: oj at July 27, 2004 1:48 PM

OJ, sure this year will be a peak for home sales. Once you pass the peak you are on the downslope. Look to the future, not the present.

Harry makes good points about liquidity. Instead of focusing on total net worth, you need to look at disposable net worth. Net worth includes everything you own. Are you going to sell your clothes, house, car and your children's toys to pay off your debts? Are you going to cash in your 401k and pay taxes and early withdrawal penalties to meet the mortgage payment when rates go up on your variable rate interest only mortgage? If you don't have liquid savings (cash in the bank or money markets), then you have to liquidate non-liquid assets at a considerable loss when you are in a pinch. Or you could put everything on your credit card.

The net worth figures are misleading, much of that amount is at risk in a rising interest rate environment. Pension funds are in terrible shape. 401Ks will suffer as bond and equity funds deflate. Remember, current equity valuations have been justified by record low interest rates, on the theory that you take the risk free yield of Treasury bonds and add a risk premium to determine equity yields and prices. As the risk free rate goes up, so will the riskier equity yields, and likewise valuations will go down.

Posted by: Robert Duquette at July 27, 2004 2:10 PM


Liquidity is overrated: in the late 60s and 70s, it was downright negative. And wouldn't you agree that for a majority of Americans, more liquidity would equate to more frivolous spending? Some would say that is not a bad thing, but....


I don't think anyone is claiming (today) that the business cycle is conquered - we heard that sort of talk in 1998-99, but not now. And in every expansion, there are warnings of "imbalances" - trade deficits, currency weaknesses, pension problems, low savings rates, exposed hedge funds, etc. - they will always be with us. Who would have thought that the collapse of the baht in 1997 wouild cause such problems? Sure the economy was (is) highly stimulated (starting in 2001), but what was the alternative? Greenspan told Congress just last week - a severe recession. You're not advocating that, are you?

Housing prices may drop 5-10% in parts of CA and Boston and other pockets (in the near future), but not in NC or GA or FL or AZ or NM or UT or WA. A nationwide decline on that level is not possible without a gross reduction in demand.

Posted by: jim hamlen at July 27, 2004 2:20 PM

A recession is the only way to cure the imbalances. The preventitive measures needed to take place much earlier than 2000. Bush was handed a no win situation with the economy, but he could have done better by insisting on spending cuts with the tax cuts. He has not vetoed a single spending bill.

The trade imbalances with China and Japan should have been dealt with by extreme pressure from the president to (a) force China to float their currency or no MFN, and (b) force Japan to not maintain an artificially low yen to dollar conversion through agressive buying of dollar assets.

Greenspan has recklessly enabled the real estate boom by even encouraging marginal buyers to use variable rate mortgages. This transfers interest rate risk from the mortgage investors to some of the most vulnerable consumers.

Bush and Greenspan need to at least make the American people know of the risks that our economy faces, and prepare them for the consequences of the market exuberance of the last decade. That is not the way to win elections or renominations, though. The weakness of our democracy is that voters will expect the government to do something to improve economic conditions, when the wisest course would be to let market forces re-balance the excesses.

Posted by: Robert Duquette at July 27, 2004 2:58 PM


No US President is going to make the Japanese change their habit of buying US debt (or US investments). As for pressuring the Chinese, better to let the yuan fall when their internal props rot away. It won't take long - maybe 5-10 years at most. They will face an awful chaos when it does. Don't push it now.

A recession is one thing, a 'severe' recession is quite another. Do you want a repeat of 74-75, or 81-82? I don't think so. Hasn't enough deadwood been cleared out (since late 2000)?

Spending cuts are a fantasy (unfortunately). I keep looking for a candidate who says that, aside from SS and Medicare, absolute spending in his 4th year will not be one dollar more than his 1st. But I'm not holding my breath. Sure, the GOP is disappointing here, but the alternative is much worse (think Carter or Clinton, with Rangel, Pelosi, and Corzine on the Hill). Democracy can be difficult.

Posted by: jim hamlen at July 27, 2004 3:46 PM

Just keeps peaking....

Who needs liquidity unless they're going somewhere? Homeowners are there for awhile.

Posted by: oj at July 27, 2004 3:56 PM


Why is it a bad thing if we come up with ideas, hire the Chinese to assemble them into finished products and then they invest what we pay them in our securities? They sure as heck can't put their money into their own society--it's a timebomb.

Posted by: oj at July 27, 2004 3:58 PM

Has anyone thought about the effect of 3/11 and the possibility of a major terrorist strike before the election having a drag on the market. Perhaps investors remember the financial aftermath of 9/11 and its effect on the market. Perhaps prudence is at work here and if so there must be one hell of a cash overhang waiting; except for the short sellers who're [no pun intended] making money betting on the threats.

Posted by: genecis at July 27, 2004 5:15 PM

Well, one reason might be that most business ideas turn out to be losers.

You want an economy with a bottom.

Republican economics busily bores holes in the bottom and never understands the value of the network.

Jim is correct to say that no US government is going to discourage Japanese from holding our bonds. We can't afford to have them cashed.

Posted by: Harry Eagar at July 27, 2004 8:29 PM

To the contrary, we could pay off every outstanding bond we have just with the petty cash in our mutual funds. That would leave $37 trillion for us to get by on.

Posted by: oj at July 27, 2004 8:33 PM

Harry: They're not holding our paper to be nice to us. They're holding our paper because they got a bunch of dollars, they refuse to invest them in Japan, their stock market has been stuck in neutral for 15 years and their own banks pay low interest.

Posted by: David Cohen at July 27, 2004 8:33 PM


Forget it--you'll never explain economics to a Stalinist.

Posted by: oj at July 27, 2004 8:45 PM


My point is that no form of "savings" that cannot be consumed by the saver is "reliable".

All surplusses of availibility over need require a buyer to monetarize the "savings", and buyers aren't guaranteed, but what else are you going to do ?
Toss the surplus into the street ?

Posted by: Michael Herdegen at July 28, 2004 1:33 PM


No form of savings is "reliable." You guys want to imagine economic apocalypse? What was cash worth in Weimar?

Posted by: oj at July 28, 2004 1:48 PM

David, I didn't say Japan was holding our bonds to be nice. I just said they're holding our bonds.

As long as we're running deficits and need to sell more bonds, we need new buyers and we need to have old owners hang on.

Liquidity, liquidity, liquidity.

US bonds are, in theory, almost as liquid as cash.

That's true if you're Hiroshi Sato in Osaka and own $100,000 worth. If you're U. Sam in Washington, D.C., not nearly as true.

Posted by: Harry Eagar at July 28, 2004 3:15 PM

If someone offered you a bond or its yen equivalent you'd take the bond.

Posted by: oj at July 28, 2004 3:22 PM

There are places to shield savings, like gold or foreign currencies (if you lived in Weimar). The reliability of savings vehicles depend on the economic circumstances of the day. Of course no form of savings is totally reliable, even stored food can go bad. But that doesn't make all stores of savings equal. Some are more unreliable than others. Market valued home equity in a stable or falling interest rate environment is much more reliable than home equity valued in a rising interest rate environment. The low interest rates that spurred the recent housing boom is a once in a lifetime event. Unless you sell your house and extract that value now, you can't count on that as a reliable measure of your net worth. You would to well to discount that wealth now, before the marketplace does it for you.

Posted by: Robert Duquette at July 28, 2004 3:25 PM

I'd take the yen. The yen is appreciating against the dollar right now.

Posted by: Robert Duquette at July 28, 2004 3:27 PM

Gold? Hopefully you didn't shield yourself by buying gold in the late '70s.

Posted by: oj at July 28, 2004 3:35 PM

No, I didn't have any money in the late 70s. But if I had had money in the early 70's, gold would have been a good place to put it.

Posted by: Robert Duquette at July 28, 2004 9:06 PM

Gold was a good buy at $35/oz.

The issue is not whether I would prefer yen or dollars. I'm indifferent, though I find on eBay that greenbacks are acceptable everywhere, just about.

The question is whether the US needs to maintain confidence in its bonds right now.

The answer is yes.

That makes us hostage to Japan.

It would be possible to unwind but awkward.

Posted by: Harry Eagar at July 28, 2004 11:05 PM


If our bonds were worth nothing we'd still be the most powerful nation on earth while places like Japan would never recover.

Posted by: oj at July 28, 2004 11:13 PM

Just think of our currency as the national stock price. Then think about how ridiculous your last statement is.

Posted by: Robert Duquette at July 29, 2004 11:34 AM

A nation isn't a company, unless MicroSoft secretly has the greatest military in human history.

Posted by: oj at July 29, 2004 12:28 PM

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