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Thursday, September 06, 2007



via aleph blog, jeremy grantham:

How this credit crisis works out and what price we end up paying has to be largely unknowable, depending as it does on hundreds of interlocking and often novel factors and how they in turn affect animal spirits. In the end it is, of course, the management of animal spirits that makes and breaks credit crises.

But even if this crisis is contained, we are facing some near certainties that should be understood.

House prices are in genuine bubble territory in the U.S., Britain and many other markets. In Britain and in some critical large cities in the U.S., for example, the multiple of family income has risen to over six times from below four times, and in London last year the percentage of first-time buyers was the lowest since records began.

From these high levels, prices are guaranteed to fall. In doing so, they will reduce consumer borrowing and spending power. They will also increase mortgage defaults, most of which lie ahead, and lower financial profits and confidence.

Second, profit margins are at record levels around the world. They have lifted stock prices directly alongside the rising earnings. They have served to raise P/E multiples as well, for surprisingly, investors on average reward higher margins with higher P/Es. This is fine for an individual stock, but for the entire market, multiplying boom-time profits by high P/Es is horrific double counting and sends markets far too high in good times (and far too low in bad times).

For U.S. and developed foreign markets, fair value (defined as normal P/E times normal profit margins) is about one-third below today's level, and for emerging markets it is about 25 percent lower.

Third, and most important, risk will be repriced. Last year a broad base of risk measures - including volatility (VIX), junk and emerging debt spreads, CD rates, high-quality vs. low-quality stock values - reflected the lowest risk premiums in history. On some data, indeed, investors actually appeared to be paying for the privilege of taking risk.

For fixed income, some spreads widened slowly at first this year and then unexpectedly widened rapidly in recent weeks. For equities, though, the process has hardly started. Junkier stocks continued to outperform into June, even as the subprime woes spread. At the end of the cycle, high-quality blue chips will once again sell at normal premiums or better.

to sum up: margin and multiple contraction to normal should knock over 30% out of equities -- and that's before factoring any possible cyclical contraction in profits that may result from a housing bust that is, he notes, still in the early innings. all in all, he's describing a halving of equity indexes.

here's a better method of applying earnings to valuations that cuts the cyclical earnings peak out.

with conditions in credit and banking markets being negatively compared to 1998, high yield spreads still widening, libor rates stubbornly creeping higher into crisis territory every day as the asset-backed commerical paper unwind takes hold... it's hard for me to imagine that equities have properly priced what is happening. it's often said that the bond guys are a lot smarter than the stock guys, and treasuries have rallied remorselessly since early june.

the ten-year yield in autumn of 1998 fell 23% -- from 5.5% to 4.25% -- from late july to october; the s&p 500 dumped about 20% of its value from peak to trough, though from the point where the decline in treasuries began to the low it lost about 10%.

in the current crisis, the ten-year yield has dropped from 5.2% to 4.5% -- about 13% so far. the s&p is currently only about 5% off its rally high, and is about flat from the point where the treasury gains began (june 12). its maximum intraday loss (to 1378) from june 12 (1492) was 7.5%.

in 1998 by the time treasuries had given up this much and libor spiked as it has, the market was already finding a bottom. is it possible that as much has already happened here?


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