October 14, 2001

Bad times bring profits too

Posted in International Economy ·
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In June 1940, the German army with no numerical advantage knocked out the entire French military and their British allies. France, which had been regarded as a major military power for three centuries, rolled over and capitulated in less than six weeks.

As seismic world events go, this was a pretty big one, yet the Dow Jones, having fallen 17 per cent immediately following the French news, recovered and was up 7 per cent by November 1941.

In 1962, during the Cuban Missile crisis when a global nuclear war was a real possibility, the Dow again wobbled but shot up by 24 per cent in the six months after the crisis. A year later, the day John F Kennedy was assassinated, the Dow lost almost 3 per cent; by May 1964 the index was up 15 per cent. The day Richard Nixon resigned, the market lost 15.5 per cent of its value, but by Christmas 1974, it had made back all its loses and posted a 15 per cent gain. The recovery from the market crash of 1987, when stocks fell 34 per cent, was even more dramatic with shares rising 15 per cent in the six months after Black Monday.

In January 1991, the markets lost 5 per cent following then president George Bush senior’s ultimatum to Saddam Hussein; by that June, the Dow was up 18 per cent. In 1998, following the Russian crisis and the bankruptcy of the hedge fund LTCM, the Dow fell over 10 per cent; six months later it was riding high, 33 per cent above its crisis levels.

This response can be summed up by the traders’ saying: “Sell the crisis, buy the war.” The markets are thinking what the world will look like when all this is over. Will we be back to normal? Have we over-reacted? Are these companies cheap now relative to where they were last year? If I don’t buy now will I miss the rally?

In the past week, the answer to all this has been conclusive: some stocks are cheap, there’s short-term cash to be made and most of the bad news has already been priced in.

Incidentally, another leading indicator for gauging a market turning either up or down can be stockbrokers’ reports. Last week, a leading broker in Dublin apparently downgraded most of the companies it analyses. But this is daft. Here are guys getting well paid to tell us that companies will have smaller profits next year. Big deal.

After the slump in profits since mid 2000 (not September 11 2001 mind), my daughter could have told me that. What is the point of telling clients what they already know? Where is the value added? The game is about advising people when things are booming to take profits, watch out for nasty surprises and in general not to believe the hype.

As JP Morgan, the king of bankers, said: “Nobody ever lost money by selling too early.” The game is not about acting like a herd, cheerleading the boom and then suddenly turning around and cheerleading the bust. It is no use in an evident downturn telling people things are going to get worse. Talk about being behind the curve.

When brokers downgrade stocks en masse, particularly at a time like this, traders should be reaching for their cheque books. The more bearish the message in the crisis, the bigger the short-term buying opportunity.

The reason I refer to the short-term is because the clouds on the global horizon are still significant and although stocks have fallen, relative valuations still paint an unusual picture. For example, on Friday the price/earnings ratio (an oft-favoured measurement of value — the lower the ratio the better value the stock) of the S&P 500 Index hit an all-time high of 36, suggesting that stocks are still extraordinarily expensive. The long-term average of this ratio is between 10 and 14.

This is because although share prices of companies have fallen dramatically, their profit forecasts have fallen even quicker, causing the ratio to rise. So, either profits have to rebound rapidly or prices have to fall further to bring things back on a long-term even keel. As well as valuation dilemmas, retail investor appetite has dried up dramatically.

For instance, September was the first month since 1975 that there was not a single new initial public offering (IPO) in the US. On the economic front, all the usual bogeymen are still lurking about. So we still face problems.

However, over the next few months the financial roadmap given to us by the 1987 crash might be helpful and could offer traders a field day. In reaction to the crash of 1987, central banks reduced interest rates rapidly and significantly. This allowed the market to recover, improved indebted balance sheets and gave investors cheap money to play around with. The recovery was sharp and substantial, but the underlying problems persisted.

Back then, the Japanese stock market displayed characteristics that are now evident in the Dow: very high valuations, significantly indebted balance sheets and a ludicrously strong currency. The US was just coming to the end of the huge Reagonomic’s-inspired fiscal expansion, the savings and loans crisis in the banking system was just emerging and junk bonds were flavour of the month on Wall Street.

While in Europe, West Germany was running the largest trade surplus ever with its neighbours and financing American largesse in the process.

These imbalances did not go away despite the markets’ recovery in late 1987/88. The interest rates reductions simply postponed the day of reckoning and fuelled the final excesses of the United States, Britain and particularly Japanese property bubbles. It took the early 1990s recession in the US, the slump in Japan and German reunification to bring the various markets to their senses. However, these events occurred a full two years after the initial crash, two years during which traders made serious cash.

Today, the financial markets may follow a similar pattern. The earnings declines trumpeted by the stockbrokers may not be as bad as expected. In the first quarter, we will probably see a series of bullish profit announcements by companies, beating analysts’ expectations hands down. With loads of liquidity sloshing around in the system, the better than expected earnings will set the backdrop for an apparently strong rally.

On the back of the upswing, analysts will believe that the crisis is over and begin the process of revising their forecasts upwards, so don’t be surprised if companies that had their 2002 profits downgraded last week will be upgraded in March.

Meanwhile, underlying problems — such as the strong dollar, America’s lack of savings and the inability of companies to achieve profit levels necessary to justify high valuations — will get worse. And, just when we thought the coast was clear, Alan Greenspan will tighten the reins as too much liquidity and the huge costs of America’s new post-war Marshall Aid plan for the Middle East, force short-term interest rates to rise rapidly.

But between now and then, most of the surprises will be positive. Friday’s figures showing that consumer spending fell by 2.4 per cent in September — the worst monthly decline on record — are not news. We knew that Americans wouldn’t be flashing their plastic immediately after the 11th. The real news will be when figures show us things are not half as bad. By then, traders will be in buying, waiting and taking profits, while companies’ cost cutting will be in place and markets are likely to move haltingly upwards.

A brief look at financial history since 1940 tells us that this pattern is likely to be the case. Although not politically correct, the market’s psychology in times of crisis can be explained by Nathan Rothschild’s famous advice, “The time to buy is when there is blood on the streets.”