Capitulation

[uncommonprofits]

 

A common theme for some on this thread is that peak unemployment is a prerequisite for the recession bottoming out.  Yet historically that is not the case -- unemployment consistently peaks shortly after the recession is over:

http://bigpicture.typepad.com/photos/uncategorized/2008/04/12/jobless_vs_unemployed.png

 

 

And another common theme for many is that the recession must be over before the market can bottom.  Again, this is not true -- here is an excellent chart that sums up that point:

http://static.seekingalpha.com/uploads/2008/12/3/saupload_stockmarketperformance_recessions_1926_2008_ibbotson.png

 

In each and every case the market bottomed out prior to the recession ending -- including the mother of all recessions we call the Great Depression.  In the two most recent (ie. 73-75 & 81-82) deep recessions of the past  -- they both lasted 16 months.  The market bottomed 4-6 months before these deep recessions actually ended.  And, the return from the bottom to the end of the recession alone was +32 to +34%. 

 

The current US recession officially started Dec/07.  So we would seem to be in the 15th month of the current recession.  The longest it took to finally put in the low would have been during the Great Depression where it took 34 months.  The second longest on record was the 81-82 recession where it took 12 months.  If the current low was put in at November then this would tie the 81-82 recession (also at 12 months).  If not then this is perhaps putting some new numbers on the chart -- question is: is it today, tomorrow, next week, next month, 20 months from now -- taking over the number 1 spot?

 

All I can tell is that the preference right now is for inflation spending and that will continue until confidence returns.  I see us being way closer to the end than just the beginning.  And there is a lot of tremendously cheap stuff out there --- especially for the smaller investor who doesn't have to go after the Burlington's and stuff that WEB does.  Don't get me wrong -- I would love to own Burlington -- I think it stands to chug out ROE's of 18-20% over the next decade or more.  The thing is, one can find much more unknown small quality situations that stand to attain at least this kind of ROE over the same period --- but they are trading at 3-6x PE instead of 10-11.  They may even have unused leverage and perhaps trading at a good discount to Book Value instead of 2x BV.

 

UCP / DD

[Partner24]

Thank you very much uncommon for all the very interesting information

[uncommonprofits]

Here is another interesting chart:

http://www.equinox.co.za/Media/images/ned_0804.gif

 

 

Instead of showing the year to year or month by month PE variables, it takes a 10 year average.  Buffett continually pounds into investor's heads to view the long term  The 10 year average would seem helpful with this. 

 

Taking a guess at 2008 earnings -- I am figuring that the 10 year average (99-08) earnings for the S&P 500 would be about $62.70.  So when considering where we were in November (S&P 500 at 741) --- we were probably hitting about 11.8x PE (versus the typical 10x or so from the graph above).  While this might be slightly higher than where it has bottomed out before --- does one wait for it to actually bottom out?  Yes, a bottoming out of the PE multiples could happen in a second Capitulation event in the next few days or weeks .... but then again it could take 5 or 10 years for such bottoming.  If today (or in any market!) -- a person can find good quality companies with nice competitive advantages trading at 3-6x PE's (or less?) why not buy them? 

 

Sure the overall market index PE may come down more --- but provided the lower priced bargain isn't some sort of big mistake --- it will converge up.  And further down the road will likely also benefit from the market rising back to normal levels.   I remember Peter Cundill once mentioning that this was the way with bear markets --- they bring about a convergence of PE's.  The overpriced comes down --- the underpriced goes up.  Overall the bear market brings with it a down draft --- but value is still value.

 

UCP / DD

[uncommonprofits]

Thank you very much uncommon for all the very interesting information

 

I should just point out that these are just charts I have found and have not had the time to check them out for complete accuracy.  With a short view and comparison of the figures used they do seem to be reasonably accurate and hence I presented them here.  If anyone finds any inaccuracies -- please do point them out.  I have saw some very odd charts that are posted around the web so one does have to be careful.  In fact the first chart on this thread seemed kind of odd --- as it was showing a price for the S&P in the 30's at a point where the Dow would have been at that time -- I could not make sense of that one.

 

UCP / DD

[Uccmal]

UCP, Your first chart sort of gets what I was talking about in regards to capitulation. 

- The markets will trend upwards long before the recession is dust. 

- Company profits will start to trend upward long before the recession is officially over.  Writedowns will be written down; layoffs will have slowed; profit margins will improve; stocks will rise

- Then, unemployment will start to drop and the GDP will start to rise above 0.

 

[Guest kawikaho]

Does today help define capitulation? 

[Guest ericopoly]

"I remember Peter Cundill once mentioning that this was the way with bear markets --- they bring about a convergence of PE's.  The overpriced comes down --- the underpriced goes up. "

 

 

Jeremy Grantham claims that during the 1929-1932 market, the high P/E companies outperformed the low P/E companies.

 

 

It has long been my view that the pricing of value stocks

has a folk memory of the Great Depression when many

cheap companies went bust and the expensive Coca-

Colas survived the best. Remember, you cannot regress

from bankruptcy. Using proprietary research data, we

examined one fi xed time slot: October 1929 to June 1932.

With no rebalancing, the data showed a massive “value”

wipeout in which high P/E stocks declined far less than

low P/E stocks.

[uncommonprofits]

 

 

Jeremy Grantham claims that during the 1929-1932 market, the high P/E companies outperformed the low P/E companies.

 

 

It has long been my view that the pricing of value stocks

has a folk memory of the Great Depression when many

cheap companies went bust and the expensive Coca-

Colas survived the best. Remember, you cannot regress

from bankruptcy. Using proprietary research data, we

examined one fi xed time slot: October 1929 to June 1932.

With no rebalancing, the data showed a massive “value”

wipeout in which high P/E stocks declined far less than

low P/E stocks.

 

Where this Grantham analysis would seem to fall short is that it makes no distinction between junk and higher quality low PE stocks.  When Peter Cundill mentioned this -- I am quite sure he was not speaking of the low PE issues that were swimming naked (hence the reason they were cheap).  I think he was referring to stocks that at minimum had accurate financial reporting, honest management, etc.  There is also the issue of hidden assets and/or earnings that are flushed out over due course. 

 

For example -- CBS right now trades at about 2x it's free cash flow in 2007.  Because of some writedown in goodwill it would show a negative PE if Grantham were to run his analysis today -- so it would really not be considered.  And some of the hidden free cash flow would not appear as earnings -- yet I would consider it a very low PE at this juncture.  At some point Sumner Redstone either gets past his personal debt problems or he is forced to put his controlling stake up for sale.  If CBS were sold next month --- it would again probably not even register in the analysis that Grantham has done. 

 

Real earnings (as they relate to PE's) do not always show up without delving into the details --- same for real losses.  The PE convergence is more about what is real and what is not real ... what is sustainable and what is not ... a broad analysis of reported earnings is a bit misguided. 

 

I have no question that a company like Coca Cola will often weather a storm better than many --- but the key ingredient here is the quality.  Find a very good quality company trading at 3-6x PE --- one could do better than the KO scenario (especially if the company is smaller size and more nimble, very underleveraged, etc).  The problem is that at the height of things in 1929 ... an extreme low PE company would have been as rare as what could be found in 2007.  But keep in mind that the overall valuation of 1929 compared more like where we were at in say 1998-2000.  The situation in 1998-2000 was that there were still some excellent values as lots of stuff was being trashed for tech stocks.  Had Grantham's study been of the bear market after 2000 -- I think the results would differ.  High valued tech stocks crashed --- with moeny going to the lower PE stuff where the smart money was already parked.

 

But for our current day situation a snap shot of 1929 - 1932 gets more and more meaningless.  We are well into this now --- and probably at valuations comparable to sometime in 1931.  So perhaps a take of how low PE stocks (prefably decent quality) performed from a starting point in 1931 ... would be more comparable to our situation today.  Where were they 5 or 10 years later -- don't forget out the ones taken over through M&A activity as the financial system thawed, etc.   

 

UCP / DD

[Guest ericopoly]

" Had Grantham's study been of the bear market after 2000 -- I think the results would differ. "

 

 

Yes of course it would, but his study was focusing on the Great Depression for a reason.  Remember the other points of that letter where he said he just finished reading The Forgotten Man, and that he is reading up on debt deflation?  He is clearly wondering whether the bear market of 2000 is really relevant... it bounced before a lot of what looked cheap in 2000 has a chance to go bankrupt.  Remember, his point is that you can't bounce back from zero, and that's why he said a lot of value portfolios were wiped out.  Maybe he's just doing this for amusement and nattering on about it because he has an audience, or maybe he is clearly worried that things are going to get pretty severe and that's why he is digging in to this reasearch.

 

But if you are buying KO at 3x earnings, then no you don't have to worry about the prospects of high P/E stocks ever outperforming KO's low 3x P/E.  His point (I think) is that KO has a relatively high P/E (both then and now) because people can't think of it going bankrupt in the most severe scenario, and that a lot of bottom fishing in moderately riskier stocks, but at much lower P/Es, might wind up at zero in a super severe situation.  I think that's what he meant.

[SharperDingaan]

 

Grantham's study made a few key assumptions:

 

The company financial structure was relatively stable at the time he measured it, & it had products that would remain in demand throughout the depression. However the reality was that if the company hadn't yet had to sell assets/take writedowns, its earnings quality was artifically high & its forward earnings projection would (typically) be overstated. He also didn't recognize that if most of your product lines are somewhat 'non-essential', in a recession/depression there is less/no market for them - & this is most companies.

 

If your coy was #1 or #2 in a cyclical industry (mining, drilling, commercial ppty, etc) & cyclical write-downs are common industry practice, your coy wouldn't qualify because earnings quality wasn't there. And if you did buy, you'd be buying closer to the peak or trough of what had already been a most often longer than average cycle. Measurement bias.

 

12 months ago the banks & car makers etc. would have been high on the list, & primarily because of their long history of prior earnings. And the riskier coys would have ranked highest because their earnings were being 'boosted'. Historic bias.

 

Grantham's is a valid analytic, but overweight forward earnings 2-3 years out & those coys with the newer & more relevant product lines. Essentially - where will we make our money 5-10 yrs out ? vs where we make it today, & are we making enough today ? to finance the R&D on those future products.   

 

SD

 

 

 

 

 

 

[Uccmal]

I have decided that we have reached inverse Mungerist Capitulation where in stocks go down no matter what.    :'(

[Uccmal]

I guess I was wrong.    :o

[Uccmal]

I guess we are never going to reach capitulation....  :'(

[Guest ericopoly]

Maybe you can settle for capitulation on an individual issue level.

 

There was a point today where LUK was down 80% from it's 52 week high.  That's only slightly better than GE which is down 80.53% from the 52 week high. 

 

How could any of the weak hands not have folded by now?

 

 

 

[scottyjukebox]

im also waiting on the private equity implosion..which i dont think will be pretty.  Im sure everyone remembers in 2005 and 2006 it was an endless amount of PE deals.  day after day after day of billion dollar takeovers and mergers and you really arent hearing anything about any of them going sour.  Back when all that was happening i thought it was nuts and remember thinking this cant go on forever.  oh well its probably too late to short Blackstone..

[oec2000]

We probably aren't done yet as I haven't seen any big headlines about private equity tripping covenants.  From some of my sources I have spoken with, some of these shops are getting damn close to not being able to service some pretty staggering amounts of debt.  If this recession gets any deeper, you might see some massive defaults.

 

Interesting take. Question is who are the holders of all this PE debt? How thses defaults affect the public mkts will depend on who is affected by this fallout. It's probably fair to assume that the banks are not major holders, apart from those loans they were unable to place out before the crisis unfolded so we can hope that this will not set off another round of bank sell-offs.

 

I would imagine that PE debt defaults would have to be settled in a more orderly manner (i.e. negotiated restructuring, chapter 11, etc) because the very nature of the assets preclude the lenders from carrying out indiscriminate selling a la margin debt. If this is the case, the impact on public mkts may be less dramatic.

 

Besides, the debt holders may already have taken the mark-to-market hits in which case the actual defaults only confirm what the mkt have already priced in.

 

Finally, on the BX conference call, they spoke about taking advantage of the distressed debt mkts to buy back PE debt at huge discounts and thus make the deals less leveraged. So, to the extent that PE funds still have undrawn capital, they could use this to improve their deal economics.

 

It's complicated but unless the banks are hit in a major way, the fallout could be more limited than you think, especially if the holders of these debt are not highly leveraged.

[Hoodlum]

Here is one example of the fallout we should start seeing with Private Equity.  I am not sure who holds the debt and what impact this would have on KKR.

 

KKR's Masonite reaches restructuring agreement

 

"The plan aims to reduce the company's debt from $2.2 billion today to about $300 million. It will also reduce the company's annual cash interest expense by $145 million, one of the sources, who is familiar with the company, said."

 

"KKR bought Masonite in 2005 and took it private for more than $2.7 billion, according to the Journal"

 

 

[DooDiligence]

Bumping up an excellent re-read (thanks to John Hjorth for pointing it out...)

 

Where in the world is ericopoly?

[John Hjorth]

DooDiligence,

 

I'm guessing and speculating here, so - I'll give a shot:

 

There is a story somewhere on here from Sanjeev a few years back, that the board got a bit overheated in some topic. Some board members started a fist fight using their keyboards [politics, taxes, some election? lol].

 

Sanjeev had to step in to avoid a nuclear melt down of the board [lol again].

 

Sanjeev then wrote, that Eric got angry and left the board, most likely also deleting his account in anger.

 

Sanjeev asked Eric to come back, which Eric did.

 

When someone on here deletes his account, his posts stay on board - no big holes in topics by that. And the deleted users accounts board handle goes from the member user group to the guest user group. CoBF is set up, so that guests can't post. The point here is that the board handle is taken in eternity, also for deleted accounts. [i.e. There will never on this board be any other DooDiligence than you].

 

I guess that:

 

ericopoly is Eric posting before he got angry.

ERICOPOLY is Eric posting after he came back.

 

- - - o 0 o - - -

 

I'll get a good laugh out this guess, if it actually turns out to be right.

[Parsad]

DooDiligence,

 

I'm guessing and speculating here, so - I'll give a shot:

 

There is a story somewhere on here from Sanjeev a few years back, that the board got a bit overheated in some topic. Some board members started a fist fight using their keyboards [politics, taxes, some election? lol].

 

Sanjeev had to step in to avoid a nuclear melt down of the board [lol again].

 

Sanjeev then wrote, that Eric got angry and left the board, most likely also deleting his account in anger.

 

Sanjeev asked Eric to come back, which Eric did.

 

When someone on here deletes his account, his posts stay on board - no big holes in topics by that. And the deleted users accounts board handle goes from the member user group to the guest user group. CoBF is set up, so that guests can't post. The point here is that the board handle is taken in eternity, also for deleted accounts. [i.e. There will never on this board be any other DooDiligence than you].

 

I guess that:

 

ericopoly is Eric posting before he got angry.

ERICOPOLY is Eric posting after he came back.

 

- - - o 0 o - - -

 

I'll get a good laugh out this guess, if it actually turns out to be right.

 

That's about right.  Eric hasn't gone anywhere.  He's enjoying retirement over the last few years...including learning to surf! 

 

He still reads the board and posts from time to time.  Cheers!