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Essays 2
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Jan. 30, 2008
WHAT REALLY CAUSED THE JANUARY STOCK MARKET MELTDOWN
Speculation has been rampant in the media, blogs, and various financial commentaries as what caused the stock market to crash so suddenly and violently this months. Of course, the subprime crisis and a looming economic recession received by far the greatest share of blame. One of the most unusual explanations we heard of is the beginning this month of the planet Pluto’s passing through the constellation Capricorn, a cyclical astrological event deemed to be a harbinger of violent cathartic transformations of society here on planet Earth.
In this essay, a less impassioned and more rational explanation is offered having to do with something as prosaic as corporate earnings, the most important factor normally nourishing and sustaining stock markets. In fact, it can be shown quite convincingly that the market’s sudden swoon reflected nothing more than a normal readjustment to a level of 2008 earnings lower than estimated earlier.
For an easy understanding of this thesis, attention is directed to the first chart of the SP500 presented below (Chart1) which shows a tracing of the index as of November 22, 2007. To annotate the chart we followed our longstanding practice to frame stock indexes within certain Price Earning ratios (PEs) channels. In the case of the SP500, PE ratios of "as reported" earnings have been fairly stable in recent years ranging between 15 on the low side and 17.5 on the high side ("As reported" earning estimates courtesy of Standard&Poor Equity Research). During the last quarter of 2007, earning estimates began to be reduced, slighly at first and then more dramatically in late November and December (from $94 to $91/share to $84/share). The lower estimates opened a worrisome "earning gap" in the chart PE channel, something that we viewed as a kind of black hole into which the market soon or later was bound to fall.
If anything, the surprise was that till year-end the market still showed little propensity to decline. Our strong feeling at the time was that institutional money managers were reluctant to engage in any serious selling during the Holiday Season. Better end of the year performances, prospects of higher bonuses, keeping fund investors happy, were some of the plausible, if a bit malicious, reasons that we considered then. A sensible corollary to this reasoning was the expectation that selling buttons would be more eagerly pressed at the beginning of the New Year. Be as it may, this situation prompted us to quickly convert our stock portfolio entirely to cash.
Fast forward to the current chart of the SP500 which is self-explanatory (Chart 2). Two features stand out in the chart. First, the precision with which falling prices landed on the lower PE line. Second, the rapidity with which the price adjustment occurred. It is obvious that in this era of instant communication and dissemination of information, investors’ action and reaction times have become greatly compressed. What is not apparent to us in the chart is any evidence of emotional, irrational, or panicky behavior.
Rather, what we easily recognize is a hurried but cold and calculated way in which the selling was carried out.
Good for us because it was this realization that permitted us to calmly re-enter the market the day after Black Tuesday.
| Chart 1 SP500 as of Nov.22, 2007 |
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| Basic chart courtesy of Bigcharts.com |
| Chart 2 SP500on Jan. 29,2008 |
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| Basic chart courtesy of Bigcharts.com |
Jan. 30, 2008
Was the Fed right or wrong to drastically cut interest rates last week?
This issue is hotly debated at this moment even as the Fed Board meets today to decide about a possible additional rate cut. Our answer is unequivocal: the Fed’s action was taken in reaction to a weak stock market and was absolutely unnecessary.
The reasons for this position follow logically from the arguments outlined in the above assay
WHAT REALLY CAUSED THE JANUARY STOCK MARKET MELTDOWN. Since the Fed’s action occurred simultaneously
with the market reaching the low earning line illustrated in the charts above, it may never be known which of two events was
more important to halt the market’s slide. However, from the evidence available from past declines (for
example mid 2006, early 2007 and mid 2007) strongly suggest that the January decline likewise would have halted at that fundamental
earning line. Accordingly, the Fed’s action is regarded as unnecessary, a clear overreaction
to what can justifiably be regarded as a normal market adjustment to prospects of lower corporate earnings this year.
Since the Fed’s action occurred simultaneously with the market reaching the low earning line illustrated in the charts above, it may never be known which of two events was more important to halt the market’s slide. However, from the evidence available from past declines (for example mid 2006, early 2007 and mid 2007) strongly suggest that the January decline likewise would have halted at that fundamental earning line.
Accordingly, the Fed’s action is regarded as unnecessary, a clear overreaction to what can justifiably be regarded as a normal market adjustment to prospects of lower corporate earnings this year.
Since the Fed’s action occurred simultaneously with the market reaching the low earning line illustrated in the charts above, it may never be known which of two events was more important to halt the market’s slide. However, from the evidence available from past declines (for example mid 2006, early 2007 and mid 2007) strongly suggest that the January decline likewise would have halted at that fundamental earning line.
Accordingly, the Fed’s action is regarded as unnecessary, a clear overreaction to what can justifiably be regarded as a normal market adjustment to prospects of lower corporate earnings this year.
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