P/E

i like long term averages.

they put into perspective short term market movements, and in return for a few minutes of contemplation, you can avoid running around like a headless chicken or joining a herd of sheep heading into a pack of wolves. i also like following quote from paul ashworth, senior economist at capital economics, who said this week: 'what's going on in the stock markets is a reflection of the fact that investors are realizing non-financial profits are going to be absolutely whacked.'

what do they have to do with each other? profits have a direct impact on the p/e ratio （市盈率） of shares, which we can compare to its long term average.

this brings us back to my initial post on this blog, where i mentioned robert shiller's long term p/e chart. i've finally gotten hold of that data here below, and it's beautiful - there is no escaping a 130 year average. u.s. stocks are currently trading at an average p/e of 15 (below graph only shows data till august), and the long term average is 16. unfortunately, as the graph shows, after high peaks, the p/e will dive far underneath the average for quite some time - that's why it's called an average - ha!

now if a company's profits fall by 50%, but its share price stays the same, then the p/e ratio will have doubled. so we can make a quick and dirty assumption that profits will indeed be 'whacked', say by 50%, which they have done in the past after the popping of a bubble. we can also assume that the p/e ratio needs to come down to 7 to work its way back to the long term average, especially considering the extent to which it has gone and remained above average since 1990, then share prices have to fall to 25% of their current levels. that means the dow at 2000. i had previously ventured 4000 and it will probably bottom out somewhere in between, depending on how badly profits will be hurt.

feeling better yet?

AS I WAS SAYING...

four days after my post where i mentioned that the likely next u.s. president might get shot, 2 men were arrested in tennessee over a plot to kill barack obama. turns out they were not that smart, didn't have a real plan, and would go dressed in white tuxedos and top hats.

PRESIDENT OBAMA

with 2 more weeks to the election, it is now quite likely the next president of the united states will be barack obama.

in the eleventh hour, john mccain has been scrambling to find new ways to scare his countrymen and women not to vote for his opponent, while the scariest part of this election is probably that sarah palin might accidentally find herself running the world's most powerful nation.

barack obama meanwhile has been able to position himself as more inclusive, and with a stronger focus on solutions for the unfolding economic crisis. he has the steadiness, the ability to inspire and the intellectual vigor that a u.s. president requires -- says colin powell. perhaps the differences in how both have organized their campaigns provides a hint at the differences in how both would run the country.

people around the world have noticed too, and on his few visits abroad it has become clear how excited they are by the idea of obama in the oval office. at least part of that is of course because during the last 8 years, the bush administration has done an excellent job driving america's reputation firmly into the ground. but most obama supporters in other countries will agree that they like him because they truly see him, in colin powell's words, as a "transformational figure".

while an obama presidency certainly holds that promise, many of his fans around the world will likely be disappointed, because:

(1) despite his sweeping rhetoric, mr. obama is a pragmatist, and if elected, he will represent all americans. that includes a lot of people with vested interests in an economic and geopolitical status quo, and that in turn immediately excludes a lot of the wonderful things that his admirers imagine he would do if he became president.

(2) mr. obama might get shot. it would not be the first time that a public figure embodying change has been silenced with a bullet in america. while they clearly deserve credit for being the only non-african country in the world that could elect a black president, there are still plenty of americans who quietly harbor disdain towards black people, although of course less than in the days of rosa parks.

some outrageous stories are circulating, according to which mr. obama is in fact muslim, arab, a communist and a terrorist. fired up by such allegations, there have been outbursts of anger directed at obama that go beyond the traditional mud-slinging on the campaign trail, with on one occasion someone shouting "off with his head!" during a mccain rally.

all it takes is one guy with a gun, and there are plenty of those in america.

for now, as obama seems to have the overall advantage in the polls, his lead is sometimes still within the margin of error, and results will still swing during the final days. he will need a comfortable margin of up to 10%, because the bradley effect is expected to cost him a fair amount of votes on election day itself, and from that angle, he is not in the clear yet.

nevertheless, taking into account all of the above, he is the likely president, and based on his overwhelming popularity around the world, on november 4, we better get ready for a global party like we've never seen before.

that will be the first immediate benefit of his presidency.

NO TIME FOR GREED YET

warren buffet publishes an opinion piece in the new york times, which instantly becomes the most emailed story on the site.

he makes three central points, which are old news to anyone familiar with mr. buffet's investment philosophy:
- investors should buy when there is fear in the markets, and there is plenty of fear now
- financial markets recover earlier than the economy itself
- it is impossible to predict the short term future of the market

he therefore has started buying stocks, and will continue to do so as long as conditions remain fearful.

now i'm trouble. only a few days ago i projected that the dow will go to 4000, and now the sage of omaha is saying "buy". even if my prediction turns out to be wrong though, there is so much more bad news, and so much more downside to economic fundamentals in the pipeline, that i believe it is perfectly fine to wait. in addition, when mr. buffet says he's started buying, that means he has allocated a small portion of his portfolio to stocks, probably in the vicinity of 5%, the rest remaining in cash equivalents. now that might not be a bad idea. the value of that small portion might drop by another 50%, but viewed over 5 or 10 years it will still have been a bargain.

does that mean we are out of the woods already? i don't think so.

ONLY THE BEGINNING

the markets have soared, and on the face of it, a lot of people seem to believe that the bad dream has ended. they are committing the same mistake as the one that got us where we are today: ignoring reality.

injecting the banking system with a bucket full of tranquilizers doesn't actually make it healthy again. and most of us haven't even realized that the banking crisis is merely a distraction. the real problem is that unrealistic house prices around the world underpinned and still underpin an unrealistic level of consumption. that will erode, and china will have to find somewhere else to ship its exports.

therefore, this is only the beginning.

IMF: WORLD ENTERS MAJOR DOWNTURN

the imf released its october world economic outlook last week, and stated: "the world economy is entering a major downturn in the face of the most dangerous financial shock in mature markets since the 1930s"

while the stark wording of the report is clearly designed to spur governments around the world into action, the imf reports are solid pieces of rigorous research.

if we remember that everything started with irrational house prices, it includes a graph on page 37 indicating the gap between where house prices are, and where they should be, according to their fundamentals, such as long term average ratios of rental prices to house purchase prices, and salaries to house prices.

this suggests that while the us has come somewhat closer to its fundamental level, it still has 7% more to go, and past experience of course indicates that instead of settling nicely on its fundamental level, it might go well below it first. meanwhile, prices in most other industrialized nations are way above, with the uk exceeding it by more than 20%. all points to further declines in house prices, which is going to hurt consumer spending, increase loan defaults, further deteriorating the conditions of credit markets, in turn depriving businesses and consumers of the lifeblood of growth and consumption.

the reports in pdf format:

executive summary (english)
executive summary (chinese)
full report (321 pages, english)

other world economic outlook reports can be found here

the case-shiller index meanwhile continues to plummet, although not as heavily as before. us home prices in july were down 17% year-on-year, from 16% in june.

SEQUOIA CAPITAL: CUT COSTS NOW

a presentation given by sequoia capital partners to about 100 ceo's of investee companies last week, contains stark warnings:

"We are in a serious economic downturn and this is just the beginning. Immediate, decisive and swift action is required, along with frugal, day-to-day management of expenses and our business."

courtesy of co-writer david.

DOW TO 4000

where is the bottom?

the answer depends on your assessment of the current turmoil in financial markets.

parallels are increasingly being drawn with the 1930's. wsj's jason zweig points out that investor benjamin graham's p/e ratio for the standard & poors 500 is now at 15. this is the lowest since 1989, but not that low compared to a long term average of 16 since 1881. the graham p/e has hit below 10 several times after hitting peaks since ww2, notably from 1977 to 1984, with a low of 6.6 in july 1982.

with current earnings levels, a p/e of 6.6 would take the dow to 4000, half its current level. the dow jones reached its bottom of 41 in july 1932, after losing 90% of its value over 3 consecutive years, from 386 in september 1929. it then took another 20 years to return to its previous peak. unfortunately, we have yet to see the beginning of corporate profit warnings and corporate failures outside the financial industry, and therefore earnings can be expected to drop significantly, which would even make 4000 look pretty.

at the same time, much is being said about the more effective toolkit at the disposal of policy makers today, which would allow steering the markets clear of too sharp a correction. while this may be true, it is even truer that there is no escaping gravity, and that eventually the result of such policies will delay, not eliminate the necessary corrections.

which brings us to the controversial supercycle theory pioneered by russian economist kondratiev, nevertheless given credence by a number of prominent analysts and corporate executives. according to this theory, we are currently in the debt supercycle, with u.s. consumption and global wealth driven by increasingly irrational levels of debt. in a september 2007 report, bca research posits that the end of this cycle will come when foreign creditors' confidence in the ability of the u.s. government to honor its obligations collapses, with massive foreign capital flight as a result, forcing a violent correction in u.s. consumption, and the end of u.s. economic and political hegemony.

the current turmoil however, is an "inflection point", not the end of the cycle, according to the report. it predicts that after a momentary correction, further excesses driven by debt will follow, likely in emerging markets and commodities, eventually leading to the end of the cycle.

taking into account all of the above would allow for earnings to drop well below current levels, but for policy measures to soften the landing, and therefore make 4000 still a plausible bottom.

cross those fingers.