I am not teaching you anything new when I say that the prices of shares are a function of corporate earnings multiplied by investor enthusiasm. Price = Earnings x Enthusiasm. The price/earnings ratio, or P/E, is how we monitor the level of enthusiasm. The faster earnings grow, the more enthusiastic investors become about future earnings. Conversely, when earnings head south, optimism tends to recede; the longer the earnings cycle stays discouraging, the more gloom tends to displace optimism. The result on prices is a double whammy ... a lower P/E ratio applied to lower earnings.
With the benefit of hindsight, we now know that when Nasdaq was bid up to 200 times earnings last March, investor optimism was out of control. True believers imagined that the business cycle had been repealed. Although Nasdaq has since been cut in half, at 100 times earnings it is hard to infer that investors have become cautious. Their sense of well-being is intact. There is no feeling of urgency. This doesn't look at all like Filene's Basement. We are definitely still in the upstairs store.
The incredibly optimistic market valuations circa 1998-2000 represent the culmination of 18 years of confidence-building stock-price gains. While investors were enjoying the last nine years without a business-cycle interruption, their mantra became "buy the dips." And every time they bought during a dip in the market, they made money! People are slow to give up what has worked. It is only during the past nine months of intermittent pain that some have begun to change their tune to "sell the rallies." If business fundamentals continue to deteriorate, you will hear a lot more of this song.
When the Federal Reserve cut interest rates last month, before its scheduled meeting, these graybeards were telegraphing their concern that the economy was unraveling faster than expected. Consumers, saddled with record debt, are pulling in their horns. Is this a surprise? Let me see, I check my 401(k) on the Internet and realize I'm down 20% in the last four weeks! I open my monthly gas and electric bill to see it's gone up $120. Then I go to the mall to shop for a big-screen TV? I don't think so!
But corporate spending on technology will keep growing, right? Sorry to disappoint the New Era buffs, but it's starting to look like same ol', same ol'. A capital spending binge leads to overcapacity, leads to price cutting, leads to lower earnings. When earnings fall, captains of industry slash capital spending and hand out pink slips.
We cannot know how long it may take for the old bullish thought pattern to be replaced with a new, bearish mindset. But it does seem probable that a bull market of the unprecedented length and magnitude of the recent one will not quickly be erased from the investor psyche. A return to "normal," if that is what lies ahead, could be a long, drawn-out process with hopeful rallies, sell-offs and gut-wrenching, emotional flip-flops.
The downside risk from this level is still quite frightening, especially if you are responsible for retirement portfolios. Business profits are still near their cyclical high as a percentage of national income, with lots of room to come down. Worse yet, the P/E measure of investor emotions is still in the stratosphere. If falling earnings should turn optimism to fear, panic will be right around the corner!
A consistent characteristic of major market moves is that investor emotions, when reinforced by financial developments, tend to run to extremes in both directions. And these extremes eventually correct.
I have designed a simple "word graph" to describe this pattern from bottom to top and back again:
The right side of this chart is steeper than the left to indicate that a market's declining phase is usually faster than its ascent. Although Nasdaq has tumbled 50% from its peak, my appraisal is that we are just entering the "fear" level on this emotional chart. Whether we will cycle directly into the panic stage I have no idea. But until we do, I do not see an opportunity to raise our equity allocations for the sake of scooping up bargains. Until mutual fund investors scramble for the exits, I don't believe we will have finished the emotional cycle.