With the Nasdaq and Russell about 20% off their highs and the Dow and S&P 15% off, valuations reasonable (“A Contrarian’s Way To Play Recession”, Barron’s interview with T. Rowe Price Capital Apprecation Fund portfolio manager David Giroux (subscription required), Friday February 8; “Heed History’s lessons and the gap between price and value”, Arne Alsin, Financial Times, Saturday February 2) and sentiment expecting a recession (subscription required) (also magazine cover indicator), one way to characterize the current market environment is to say that a mild recession is now priced into stocks.
In other words, it is not early in the game anymore and the easy money on the short side has been made. Financials, Retailers and Homebuilders are all down at least 30% from their highs and have been acting like we’re in a recession for a year now. If stocks are going to fall further, the move probably won’t be led by those groups.
If that’s correct, the question investors need to ask themselves is if they think we’re in for a mild or a severe recession (see, for example, Forbes recent profile of the new Dr. Doom, Nouriel Roubini, “Look Out Below”). If the former, then it’s starting to look like the time to begin hunting for bargains. If the latter, then you continue to buckle down and be defensive.
The only way I see prices coming down a lot more is if we see a pretty bad earnings recession. That’s because, like I said, valuations aren’t high at current earnings levels and multiples. They could be high, however, if valuations are being calculated on peak earnings that will be hit by 20%-30% or more from peak to trough. In that case, a reasonable 15 P/E multiple becomes an expensive 20 P/E multiple and the stock price will come down significantly.
That’s how I am orienting myself in the current environment.
UPDATE (Mon 2/11, 10:15am PST): In his Streetwise column in Barron’s this weekend, “What Does The Market Know?” (subscription required), Michael Santoli addresses the same issue: “Our challenge, then, is to determine what’s already expected by the market and handicap the odds of reality coming in better or worse than anticipated.”