Bear Market Likely to Continue

The odds are mounting against a return to DOW 14,000 anytime soon. There will be short-term bull rallies, but it seems likely that the bear that gripped the market in 2007 will hold on for many years. The conceptual if rudimentary explanation for my market pessimism, especially over the long term, is illustrated by the simple formula: Price = Earnings x Multiple. Stock market prices (Price) are the result of a complex and dynamic relationship between actual after-tax corporate earnings (Earnings) and the extent to which those earnings are expected to grow over time, which is reflected by a stock’s price/earnings multiple (Multiple). Obviously, stock investors would like to see all their stocks’ earnings and multiples expand steadily over time.

No one is predicting corporate earnings will rise in the next couple of years. The consensus view is that the current recession will last at least as long, which means GNP could fall and unemployment could rise well into 2010. Falling home prices and exorbitant consumer debt levels will curtail consumption and earnings levels accordingly. The Government’s Stimulus Plan may reduce corporate taxes and thereby modestly lift after-tax earnings in the short-to-medium term, but eventually tax rates will need to rise to pay for the currently exploding Government deficit already exceeding $1 Trillion.

Multiple expansion seems unlikely too. Although both macroeconomic and company-specific factors dictate their magnitude, multiples generally rise when inflation and interest rates are low or falling and overall economic and political risks are perceived to be minimal or contained. Inflation is low right now because of worldwide recession and deflation in global real estate values. Interest rates are artificially low because of the concerted efforts of the world’s central banks to pump unprecedented liquidity into global capital markets. Many observers expect those conditions to abate once the financial crisis and recession subside. Also, as the BRIC (Brazil, Russia, India, China) economies and others catch their breath and resume their heady economic growth and concomitant demand for resources, their growth will once again place significant price pressure on world commodity markets, especially oil, industrial metals and food. Consequently, accelerating worldwide inflation is reasonable to assume for many years to come. Inflation and growing government deficits around the world will inexorably push up global interest rates. Geo-political risks are already high and can be expected to continue from on-going turmoil around the world.

While resumed growth may be good news for the earnings side of the equation, high inflation, high interest rates and heightened geo-political risks are bad news for and likely to depress stock multiples in the future. Also, it should be noted that most of the upside in the stock market in recent decades has come from multiple expansion, not earnings growth.

The gloomy short-to-medium term outlook is likely to eventually work itself out, but no one seems to be considering the potential short and long-term negative effect that market shenanigans of past couple of years may have on investors’ attitude and appetite for risking new capital.

Unprecedented recent price volatility in our global capital markets has shaken our understanding of how they work and interact with each other. Americans lost $11 Trillion in wealth in less than two years. Even our heretofore absolute faith in U.S. Treasuries as the planet’s sole example of a risk-free financial instrument, and the basis of comparison for all global investments, has been called into question along with the overall credit-worthiness of the U.S. Government. It boggles the mind that in one year more than a dozen venerable financial institutions were lost or temporarily saved, some of which date back to our nation’s founding and early history, such as Citigroup and Lehman Brothers. These dramatic events occurred quickly and without warning and have caused many to lose faith, with good reason, in corporate and political leaders. All of these factors have materially and perhaps permanently increased the perceived if not actual risk of making investments. Reluctant investors demanding better risk-adjusted returns could reduce the availability of capital and raise its cost in the future. The end result: future stock multiples may be permanently reduced.

Based on the foregoing, and barring some unforeseen positive catalyst that dramatically increases economic productivity, or excites investors or changes the perception of market risk, such as the widespread use of the Internet in the 1990s, it is difficult to imagine a significant upside surprise in the stock market for a long time.