More on the markets - 03/12/03

To my fellow investors:

My recent piece on Templeton's view of the future is incomplete in two ways.

First, it doesn't describe the reasons behind his thinking: bearish
in the 1960s, bullish in the 1980s, bearish today. John looks
primarily at valuations. He emphasizes price/earnings levels.

He bought his Japanese stocks in the early 1970s. The Nikkei was
trading at seven times earnings. (The Dow was 14 times earnings
then.) He bought the cheaper stocks. He told me that he never paid more than 3.5 times his estimate of earnings for a Japanese company.

During the 1980s, the Nikkei reached 30 times earnings. He
commissioned a study to see if any major market, anywhere in the
world, had ever traded at 30 times earnings. The answer was not one, anywhere, ever. So he began selling.

The Nikkei eventually reached 65 to 75 times earnings, depending on the calculation of cross holdings. It was almost 40,000 in January 1990. Now, thirteen years later, the Nikkei is under 10,000. The Taiwan Weighted Index peaked at 85 times earnings in January 1990. It fell 80% - from 12,500 to 2,500 - in less than a year. It is below 5,000 today. These were the only two markets I had ever found that traded above 30 times earnings - until the bubble.

Then the NASDAQ 100 index, which has 100 of the more substantial OTC companies, traded at over 100 times earnings in 2000. This was the greatest stock market bubble ever for a major market. The S&P 500 index, which peaked at 22 times earnings in 1929 and at 23 times earnings in the mid 1960s, traded at 33 times earnings in 2000! We all know what happened in 1929-1932, and 1973-1974. This may give some more credibility to Sir John's forecast.

Second, my article does not describe the mechanism which caused the boom and bust in the economy and the markets. I have now found the smoking gun. Leon Levy points it out in his fine book, The Mind of Wall Street. He says that every 1% change in the US savings rate affects corporate profits by 10%. This is because decreased savings causes increased consumption and vice versa.

Our savings rate averaged 8% during the last 50 years. It fell from 10% in the early 1980s to under 1% in 2001. This allowed increased consumption. The extra consumption stimulated the economy. The stronger economy created rising earnings, earnings growth rates and p/e multiples. This explains the bubble.

The savings rate has now risen from 1% to 4%. This has created the poor earnings and lower multiples of the last two years. If it goes to 8% (my guess), that will cut earnings more. Maybe it will only go to 6%, which is at the low end of the typical 6% to 10% range of the last 50 years. This will cut earnings by 20%. Price/earnings multiples will certainly shrink if growth becomes negative for several years.

The S&P 500's earnings will surely stay below $40. The multiple could easily fall to ten. That puts the S&P below 400, versus over 800 today. I can easily see the market dropping 50% during the next five years.

One can never know the future. At the same time, if one sees winter on the horizon, better button up that overcoat! And allocate some capital to short-biased managers, hedge funds, futures managers, and others who have shown they can do more in this bear market than just hibernate.

With best regards,   

Douglas Sperry Makepeace
Sperry Fund Management Corporation