5/10/07 - US Stock Market drops sharply: Is a big bear market crash about to crush investors?

Stock prices have made strong gains over the last five weeks thanks to first-quarter earnings that handily beat forecasts, plus many corporate deals and mergers, and ongoing stock buyback plans. This rapid climb since early March has left the Dow at an all-time high, the S&P 500 just a hair below its all-time high and the Nasdaq at a six-year high. After such an advance, stocks were vulnerable to some pullbacks, and today we experienced a bit of that as the markets fell back toward earth. So is this the beginning of a larger series of drops leading to a major stock market crash?

Last Wednesday morning I read with interest an article by Chris Laird, a well-known and respected writer / investor (author of the prudent squirrel). He is now calling for his clients to get out of the stock markets and into cash and precious metals like gold. His main point is that the world is experiencing a financial bubble that is about to pop. According to him, every stock market is now infected with excess cash – the hedge fund frenzy for making very risky deals, record margin leverage by individuals, and record lows of roughly 3% of general investment funds cash balances. For every dollar out there many more are borrowed on leverage, and invested into stock markets world wide pumping them ever upward. The Yen carry trade is one prime example, and there are many other examples of massive world leverage in markets of every type. The overall concern is that stock markets are now in a synchronized worldwide finance bubble, and everything from stocks, to bonds, to commodities, to include precious metals, is infected with speculative froth.

Laird’s primary example of this is China’s Shanghai stock market, which is looking more and more like a speculative bubble waiting to implode. The danger signs abound: The benchmark Shanghai Composite index is up 50% already in 2007, following a spectacular gain of 130% in 2006. On Wednesday, it shot across the 4,000 threshold to close at a record high of 4,013.08. China’s listed firms – most of them large and lumbering state-owned giants for which there is little reliable financial information – are now trading at lofty multiples of nearly 50 times earnings.

Chris Laird made some good points in his newsletter, and there is little question that someday the piper will need to be paid for this excessive liquidity, and a big market crash will be the price that is due. Indeed it will likely start as a round of Asian stock market crashes, leading to intense yen carry trade unwinding, with likely EU and US market crashes to follow. So is a deep recession and a brutal bear market really just around the corner? While I think he is generally right, I also believe he is about 3 to 5 years too early. He points to one extremely tiny market, which is indeed nearing the top of a bubble, and he projects that this particular drop-in-the-bucket Chinese Shanghai market is going to collapse the whole system. It’s just nuts – the Shanghai market crashing the world financial system would be the sub-atomic particle that broke the camels back, and the camel isn’t even loaded down yet. No, before a synchronized world stock market crash and recession can happen, the big markets in the US and EU as well as the rest of the world will have to become far, far more highly valued than they are now.

The truth is that the US and Euro markets are just now starting to warm up. While we are reaching index price levels not seen in 6 years by the SP500 (a nice broad market measure), things have changed since 2001. In the last 6 years, earnings have increased substantially, while the value of a dollar has decreased substantially. In fact, corporate earnings have soared 115 percent since the fourth quarter of 2001, when the last recession ended, even though the SP500 index is up only 35 percent over that same time period. When the PE ratios on the SP500 reach numbers like they were at their highs in 2001, then we will have a bubble in the US market. The long term PE average for the SP500 since 1985 has been 15.4. Currently we are at 15.5 – hardly an overheated reading. The record PE ratio on the SP500 was 25.5 set in 1999. So the SP500 needs to increase another 60% or so in price before it gets close to that point. The big money markets in the US, Europe, Japan and elsewhere are not over heated and nowhere even close to a bubble right now. While market corrections and volatility will undoubtedly happen from time to time, there is little question that stock prices still have some ways to go to catch up with the earnings growth already achieved the last few years. However, I do think they are headed toward a bubble burst eventually, which is why I think Chris Laird is about 3 to 5 years ahead of himself.

It always pays to keep a close eye on things and protect your investments, but don't panic. Never stand idly by and allow yourself to take a bath in the market, but concerns of an imminent bear market stock plunge are far overblown at this point. The historic evidence points toward good growth in the markets for some years ahead. I'm looking forward to it.

Chris

Chris