Don’t Wait To Hit Bottom

As this is written, the financial panic of 2008 is in full swing. Equity markets around the world are being slaughtered by waves of selling. The most recent debacle is the forced fire sale of Bear Stearns, but we can be sure that tomorrow and the day after tomorrow there will be additional disasters as financial institutions, hedge funds and individuals rush to de-leverage, setting off a vicious cycle.

Wise men to whom we should listen respectfully (such as George Soros) are saying this is the end of the 60-year post-World War II supercycle, and the secular abyss looms. However, after living through (and surviving) nine panics over the past 45 years, my intuition is that we are close to the end of this one, and that markets around the world are poised for a rally that could be as violent as the decline. It sounds dramatic, but the Dow Jones industrial average could rise a thousand points. Here are the reasons why:

First, stocks around the world are cheap. We employ a variety of valuation models based on earnings, free cash flow, book value, interest rates and inflation. They show that equities are either very cheap (versus interest rates) or moderately undervalued (earnings and book value). All other busts began with stocks at extremely expensive levels.

Second, U.S. equities in particular have already had a big decline. The S&P 500 in nominal terms is more than 20 percent below its high of eight years ago (far more when adjusted for inflation) even though earnings and dividends have risen 30 to 40 percent. The emerging markets as a group are selling at about 12 times earnings despite superior growth and not really being involved in the U.S. credit crisis.

Third, the world is still healthy. The European and Japanese economies are weakening, but not collapsing. The emerging countries now account for 30 percent of world GDP and will grow roughly 5 to 6 percent in real terms this year. The big locomotive, China, will slow to perhaps 10 percent. World GDP growth should be in excess of 3 percent. That's hardly a disaster.

Fourth, the U.S. economy is in a mid-cycle slowdown or a mild recession at worst. The weak dollar has made America very competitive again, and exports are growing and new plants are being located here. The federal government's stimulus program will boost activity by late spring, and the worst of the home-building collapse is probably behind us. American companies around the world have paid down debt, have large amounts of liquid assets and are poised to increase capital spending. The biggest American companies, which dominate the market averages, earn almost half their profits abroad, so the weak dollar actually boosts their reported profits in dollars.