One of my favorite dinners is bar-b-q baby-back ribs. As much as I like all things pork, I find that it is the sauce that really makes the ribs experience. We like our home-made rib sauce so much, we joke that you could cover an old leather shoe in it and still find it tasty. This, I maintain, is an accurate depiction of the US economy at this time, I’m sorry to write. I think our economy is very unattractive, and even though the Federal gov’t has dunked the shoe with copious quantities of really good tasting rib sauce, underneath is something unsavory. As a result, the US equity market is bound to either see losses from this point or be dead money in broad measure for years to come.

I know I’ll get a couple emails from angry readers indicating the USA remains a vibrant economy with flexible labor markets and that there are worse places to invest. That’s true. Europe, Japan, and Russia come to mind – all for different reasons. But just because somewhere else is a worse opportunity does not mean we have a reason to remain invested in US equities right now – S&P500 at 950 in early June 2009.

In an effort to keep this succinct, I will use bullets to present the supporting evidence for my assertion that the US stock market is over-priced:

• Sustainable economic growth, and corresponding bull stock markets do not begin when Price:Earnings (P/E) ratios are at levels much greater than their long term average (of 15). Rather, sustainable bull markets are launched from markets that are undervalued.
• Case in point: the 2003-2007 US equity bull market. We entered that bull market with a P/E of 28 (as-reported earnings used, not earnings from operations). We now know how that ended. Those that paid attention to this were able to minimize losses.
• Where is the P/E for the S&P500 now? I’ll give you three P/Es. They range from horrific to terrible.(all data from S&P’s website)
  • 2008 P/E (based on Jan 1 2008 price): 98
  • 2009 likely P/E: 33
  • 2010 forecast P/E: 28
  • Bull Stock markets go to these levels to die!

• Collectively, the P/E data points above explain why the US stock market declined so rapidly, and they also foreshadow that the markets are over-priced now.
• We can either have the US stock market trend sideways for many years (5+) while the economy grows into the shoes that the stock market has built, or we’ll see a sizeable stock market collapse again – to levels supported by earnings. Maybe we’ll see some combination of both.
• If you do the math, you’ll probably end up with an S&P500 fair value somewhere around 540 (2010 earnings of $36 X long term P/E avg of 15 = 540). Don’t bother doing the math with 2008 or 2009 earnings. You’ll scare yourself.
• Over the past quarter century, the US consumer has taken on more debt, reduced savings, and become a much larger portion of the US economy (from 60% to 70%). In other words about 10% of the US economy was built on nothing but debt. Thus, the economy needs to grow into the capacity we over-built. Expect that to take many years since US industrial capacity utilization is at levels not seen in many decades (very low levels).

• Over the period from year 2000 through 2007, the US consumer spent like a drunken sailor. During this period in time, the consumer added almost as much debt to their personal balance sheet as a year of salary.  Think about that for a minute because it is hugely significant…
• During the same period (2000 – 2007) consumers extracted $2.3T from their homes in the form of home equity loans. The great ATM machine has its limits, after all.
• Almost 1 in 10 households in the US with a mortgage missed a payment in the first quarter of this year- and the trending is worse.

Here comes the federal government Bar-B-Q sauce. Their concoction consists of 2 ingredients:

Ingredient 1: The Bank Stress Tests

Faced with a lack of confidence in the US banking system, the federal government needed to take bold action to convince the public – indeed the world – that the US banking system was not going to fail. I support that objective, but first the government should have taken steps to ensure the system would not fail, rather than merely build a marketing strategy to portray that it would not fail i.e., the bank stress tests.

The stress tests are now known to be useless because the current economy is worse than the worst case scenario for the stress tests. I want to point out that the stress tests also tested to a very low threshold. To put in terms we can all understand, let me use this simple example. The bank stress tests only held banks accountable for approx 5% of equity. That is roughly similar to you being able to get a loan / mortgage with only 5% down. How likely is that to happen these days?  Let’s ponder why that is. If you own an investment (say your house) but only have 5% equity, 100% of your equity is wiped-out if the asset (your house) loses 5% of its value. Hence there is a good reason to require home owners to have 20% or more in down payment, and there is a good reason banks should have more than merely 5% in equity.

The bank stress tests now inadvertently show that many of the largest banks in the US are insolvent. Is that the environment you want to be exposed to by holding equity positions?

Ingredient 2: PPIP (Public-Private Investment Program).

PPIP was announced earlier this spring and becomes reality July 1st. I recall the stock market shot-up violently on the day it was announced. The objective of PPIP was to get the so-called toxic waste (mortgaged backed bonds, CDSs) off bank balance sheets. It was hoped to ease $1T of toxic waste but my bet is that somewhere between $0 to $40B will be transacted. The program was a good idea since we are not likely to see credit flowing freely until banks are solvent – for this, they need the toxic waste off their balance sheets.

PPIP may be pronounced dead on arrival by all except perhaps the US Treasury. PPIP was supposed to work by creating an incentive for private equity to buy toxic waste with sweet incentives from the government. It appears the incentives were sweet enough to entice several purchasers, but the program failed to address / incent banks to sell. Essentially you have a situation where buyers are willing to pay 50 cents on the dollar, but the sellers still want about 90 cents on the dollar. No deal will get done with a bid-ask spread that big.

PPIP will fail because bankers will not sell their toxic waste even at the improved prices they are offered (and to be fair, many value the toxic waste at far less than 50 cents on the dollar) via PPIP because doing so will mean the bank would be insolvent or nearly so. And so our banking system remains every bit as weak as it was last fall in that banks are not solvent if they mark their loans to where they are valued. It’s a good thing the government changed accounting rules to allow banks to not have to value their toxic waste at market prices. This should be a signal: government is watering down accounting standards. Do you feel safer from this action? I don’t.

Pour the ingredients into a bowl, hype it with some news conferences, add some long-only biased financial news reporting (hey, it’s always a good time to buy my fund) and voila! – the biggest stock market rally in the history of the US equity markets since the 1930s. Too bad it is not justifiable based on fundamental & economic data. As a result, we are likely to see a stock market correction back to March 2009 levels this fall or winter as the impact of a very weak economy sinks in.

This mess is not going to be fixed via a 40% stock market loss lasting 20 months (Oct 2007 – June 2009). That’s what we’ve seen so far and it is nowhere near deep or long enough. Recall the last bear market was 30 months long and had a 5 month period in the middle where it crept up, thus lulling everyone into a sense that the worst was over. Then it fell 29% more in the next 12 months.

The economic situation we find ourselves in is a crisis. It involves a noxious cocktail of liquidity, credit, and solvency. But as painful as 10% unemployment is (where we’ll be by the end of summer/ fall), the federal government is not letting our society feel enough pain. Instead we are seeing a socializing of the pain – to the federal government’s balance sheet. This increases the possibility that the US equity markets will be dead money for many years.

I like my ribs with lots of sauce. I like my economy without rib sauce.