Thursday, March 5, 2009
PE Ratios and Life without Credit
I begin this blog after diligently trying to determine the future projected price to earnings ratio of the S&P 500. I didn't have much success because the projections varied so wildly over the next 12 months. The S&P 500 indices actually posted its first ever negative aggregate reported earnings after AIG recorded a $61.7 billion loss in Q4. Add the enormous de-leveraging element to the multiples of earnings investors are willing to pay and you won't be surprised at a stock market that is half its value from a year ago. But what I don't agree with are the pricing scenarios that assume the economy will continue to live on a zero credit diet. We've gone from one extreme to the complete opposite in no less than 6 months time. The secondary credit market is illiquid, particularly now. Why? Because all of the participants are one in the same. All are financial intermediaries. Hedge funds, financial services firms, investment banks, etc. The securitized credit market took off, it fed on itself in a positive feedback mechanism, and fell of the cliff just the same. There is no liquidity or buyer in this market because the overwhelming majority of the financial intermediaries have had huge losses. Not to mention, there is no trust about the quality of the product being sold, whether counter parties will be around long enough to provide credit enhancements. Now, probably for our own good, assets are being priced as if a world economy with credit is a thing of the past. I believe the palpable panic in the market is driving prices (particularly equities) past "fundamental" values as reasonably foreseen in an economy with a "reasonable" credit system. What I'm driving at, is the perception of future value is out of touch with the perception of future conditions. Do we really foresee an America in 2 or 3 years without a credit market? I don't. Particularly with our new insight to how critical its proper functioning is. I foresee a transparent credit exchange, severe regulation of intermediaries that will re-instill trust in the market, "skin in the game" requirements for all participants, and a simplification of credit products. In our moment of panic, let's not forget that innovation depends upon trial and error and just because systems are flawed, doesn't mean they are eliminated all together. Typically those systems are refined or adjusted until they can serve our means more effectively.