Tuesday, November 04, 2008

A Clear Path to Wealth

The markets have mapped a clear path to great wealth.

The value of a stock is the companies earnings times the companies PE ratio. The future price of a stock is the future earnings times the future PE ratio. Company earnings are more stable than are PE ratios but the market is now discounting projected earnings that will be low for the next couple of quarters.

After peaking in 2000, PE ratios have come down dramatically. The next solid move up in earnings will be accompanied by a solid move up in PE ratios.

With inflation headed to low stable numbers, PE ratios should expand dramatically over the next couple of years. When the 10 year bond rate is around 5%, it is normal for the S&P to have an average PE ratio of 20. The 10-year rate is well below 5%.

When the yield curve has a 3% spread, it is normal for the economy to grow by 3% or more within two quarters. The US yield curve has been at 3% or better for several months and now the UK, EU and other nations are joining the party. If the economy grows by 3%, it is normal for companies to earn profits of 3%. GDP and earnings should rise next year.


The huge drop in manufacturing, the huge drop in auto sales and the huge drop in short interest rates are all a function of a weak economy. The market discounted this weakness weeks ago. The huge moves down in commodity prices is about to flood consumers pockets with cash. The bad news of lower prices for sellers of commodities is good news for the buyers of commodities.

Local investors have been hit as hard as almost anyone. Wachovia Bank is down 83% for the year. GM (GMAC has substantial employment in Winston), US Airways (Piedmont Airlines), and even Reynolds American are down sharply. However, it does little good to look backwards, even to note that Wachovia shares went up about 83% in October. It takes a massive move for a stock to be up 83% for the month but down 83% for the year.

The price of oil had its biggest one month drop ever in October, down 36%. Today, the wholesale price of gas dropped another 13 cents. Retail prices should be around $1.96 in a couple of weeks. Declines of 6% in a day are rare, but welcomed. Many months ago, I wrote about how the price of oil was going to fall back to the marginal cost of production. At the time, I did not know how dramatic the decline in consumption would be. I talked about the marginal cost of production as being something like $55 to $70 for those last barrels needed. Now that consumption has dropped so hard, the marginal cost of the last barrels being bought is even lower. OPEC theoretically cut 1.5 million barrels of production per day, but production is being added from such places as Brazil and Angola. The cost of the barrels being added is probably less than $40. Don't hold your breath but the price of gasoline could easily make it back to $1.30 within a couple of years.

The housing bubble has gotten the most blame for the current recession. We should remember that the steady climb in energy prices probably contributed just as much to our problems. Both problems are starting to ebb. The price of energy is going down, dragging interest rates down while home prices are set to move up nicely over the next 15 years.

The US just saw the best US Dollar rally in many a moon. The dollar was up 7.9% in the month of October. The higher dollar will lower import prices for us, but make our goods less competitive over seas.

Doomer's still have plenty to whine about. Last month, a guy that was crying the blues because credit card debt is high is now crying the blues because banks are being more careful about who can get credit cards. The big drop in auto sales is a function of this tighter credit. The big financing arms of the motor companies are temporarily frozen out of the bond market. These companies issued 9 billion dollars worth of bonds in October 2007 and only 500 million in October 2008. Now that the credit markets are thawing, GM is kicking off a "red tag sale" that will pressure prices at all dealers. Just remember that the end of the 1991 recession was around March but auto stocks took off around September of 1990, when dealers offered special terms on new models. GM has more models that get 30 miles to the gallon that any other company. The situation at GM and Ford looks bleak but the prices of the stocks look even worse to long term holders. Many a consumer will take advantage of easy buying terms to trade for more fuel efficient cars before "the price of gas goes back up".

The year over year change in the 1-year treasury rate produced a dramatic fall from early 2005 to early 2008. The rate has since moved up a little. The prior bottom was November 2001 and a solid move up occurred before the broad market took off 11 months later. Financial stocks, including REIT's went up well before the broad market.

A clear path to great wealth is mapped out before you. Falling prices are making discounted future cash flows all the more valuable. Australia has lowered short rates by 75 basis points, following a 50 basis point move only a couple of weeks ago. The cost of money to millions of consumers and businesses in Australia has fallen by 17.8% in two weeks! Interest rates are blazing a trail for us all!