These aren’t happy times, but they’re historic ones. The Dow Jones industrial average suffered its worst June since the Great Depression. In July it crossed the threshold into a bear market, dropping 22% from its October 2007 high.
The liquidity crisis continues to unfold, proving far worse than even the most pessimistic Wall Streeters expected. Several months ago most market savants thought the biggest banks had worked through the worst of their hits from bad mortgages and collateralized debt obligations, raising enough capital to make up the losses they were taking. Now a second wave of big writeoffs is occurring, along with markdowns by midsize banks with large burdens of construction and real estate loans. Financial and real estate stocks have dropped to new lows. The KBW Bank exchange-traded fund is down 59% from its February 2007 high. Financial institutions have raised capital 42 times since June 2007, almost always at large discounts to already depressed market prices–and every one of those issues is now losing money for its investors.
The government is under intense pressure to avoid additional bailouts like the one of Bear Stearns , even if it has effectively guaranteed that it will keep Fannie Mae and Freddie Mac afloat. But benign neglect will not do. A run on an investment bank such as Lehman Brothers could lead to panic, as trillions of dollars in derivatives guaranteed by investment bankers, banks and hedge funds threatened to collapse. A single big investment bank’s default might make its competitors seize up too, since nobody can unravel who owes what to whom.
Analysts’ estimates aren’t helping. They tend to be well off the mark in the best of times, as I explained in my June 5, 2006 column, “Unpleasant Surprises.” Right now they’re too optimistic for both the second half of this year and the first half of next. They’re predicting year-over-year earnings gains in both periods for the S&P 500, when in all probability there will be drops. In other words, if there is no further fall in stock prices, the price/earnings ratio of the S&P is going to move higher. The index is currently trading at 14 times estimated earnings.
Finally, the Federal Reserve Board is in a bind. It can’t rescue an illiquid economy without boosting inflation, and inflation is already high. Prices for energy and industrial and agricultural commodities are rising faster than they have in a generation. The Fed can’t raise rates or it will risk making the liquidity crisis even worse, so it dares do nothing but jawbone, even though long-term Treasurys should be yielding at least one to two percentage points more than they are today.
Should you flee the market, given all this? It’s a tough call, but I wouldn’t. For one thing, the Administration and Congress can play a much larger role in alleviating the liquidity crisis than they have up to now. This being an election year, I have a strong feeling we’ll see considerably more help from them in the next few months. Most likely the Fed will eventually move to fight inflation. Raising rates usually hurts the markets at first, but over time stocks have been one of the best inflation hedges you can find.
In these circumstances, I wouldn’t try to be too clever. You don’t see market timers who own yachts. If you pack up now, chances are you’ll miss a good part of the next bull market. A large part of the gains are always made in the first few months of one, when market-timing investors are still on the sidelines.
If the market slide continues, you will get opportunities to buy first-rate companies when they dip on negative news, such as an earnings miss that analysts and investors overreact to. When that happens, you should sell less-promising stocks to raise cash to buy the companies the market has panicked on.
If you don’t already own any oil and gas explorers, buy some shares now. Some companies that have strong fossil fuel reserves are trading at multiples of their trailing earnings that are below the S&P’s multiple of 15. The oil producers are also down from their highs of late May. Despite oil’s price rise to $130, analysts are still basing their estimates on a price of $100 or so, which could cause some pleasant earnings surprises in the next quarter or two. Here are three oil stocks I’d look at: Apache Corp. (114, APA), which is at 12 times earnings, Devon Energy (102, DVN), at 14 times, and Tesoro Corp.(16, TSO), at 6 times.
Bear markets are the hardest kind to invest in. But they can also be the most rewarding.
David Dreman is chairman of Dreman Value Management of Jersey City, N.J. His latest book is Contrarian Investment Strategies: The Next Generation.