• Martin Sosnoff

Beyond The Valley – A Perilous Wasteland

One morning at Newport Beach, 50 years ago, I opened the sliding screen door of my room and walked out on the balcony that faced the channel. In the gray light I saw 4 shell crews racing abreast, urged on by their chattering coxswains.

Suddenly, I felt old and stodgy. It was barely 7:00am, but such Jack Armstrongs were engaged already in their antiseptic world. A row of glistening white enameled cruisers jutted out rakishly in the still but murky waters. Facing me, 30 feet away, was a khaki-clad geezer methodically hosing down his deck. When I came back from breakfast, my compulsive cleanser in the baseball cap was polishing brass railings on the cabin cruiser’s upper deck. Later, he buffed the ship’s bell and squeegeed the windshield on the bridge.

The orderly world of entrenched wealth can go on, I thought, even with the valuation shrinkage for leading equities pervading in the deep recession of 1973 - ‘74.

1973 - ’74 Recession’s Valuation Carnage

Note the compression in price-earnings ratios

Nearly 50 years later, we’re operating in a pricey financial setting filled with potholes. The market sells near 20 times bullish projections of earnings power. Such a multiplier normally is awarded solely in a healthy business setting with minimal inflation.

Don’t expect the FRB to relent before it takes up Fed Funds to 4%. Even then, the rate of inflation in the country is unlikely to subside rapidly from what looks to me over 6%. The cost of doing business in a Covid-ridden world is relentlessly demanding. A year ago, oil futures traded in mid-fifties. Nobody projected their doubling, but here we are over par.

My long-term charts on price-earnings ratios are harsh when Treasuries yield 5% or more. It shows at best a mid-teens price-earnings ratio prevails. This is what you can expect to see soon. In panics like the financial meltdown of 2008 – ‘09, stocks sold at book value and yielded 5%. A haircut like this currently would take the S&P 500 down some 50%.

Warren Buffett, is energized of late, ready to take his 20% position up to 50%, in Occidental Petroleum. As yet, cash reserves sit over $100 billion in Berkshire’s equity portfolio of $327 billion. Geico, its preeminent fire and casualty property, in its second quarter swung to an underwriting loss: The negative annual variance, around $1 billion, is explainable by rampant inflation in auto parts and claims frequency. Inflation in the construction sector along with parts shortages take their toll in the cost of doing business, everywhere.

As yet, the Street refuses to deal with any serious impending negative scenario. Rather, it’s conjuring how soon GDP reaccelerates and we see a gusher of profits. The consumer spends more even as inflation and interest rates take their toll. This of course is a non sequitur everyone ignores, but it goes on.

Many money managers around today were too young to have experienced any more than the 2008 – ‘09 meltdown, that hit not just banks and brokerage houses, but the heart of our economy. General Motors needed a major bailout (not its first).

Note the destruction of NASDAQ 100 properties at yearend 2001. Microsoft got off easy with just 20% shrinkage, but Intel, Cisco Systems, Qualcomm, Oracle and Sun Microsystems bit the dust, down between 60% and 78%. Inktomi sported a market capitalization over $1 billion while Microsoft stood at $344 million. Shows you how crazy stock prices get. Yahoo, at its peak, sold at over 10 times revenues. (Gimme a break!)

Fourteen years later, February 2015, Microsoft sold at $349 million, practically unchanged from 2001, when it sold at 3.5 times sales, actually, an enticing valuation for those not stuck solely on price-earnings ratios.

Lest we forget, Paul Volcker plunged the country into its gut-wrenching recession in 1981 - ‘82. FNMA’s 5-year notes soared to yield 15%. The S&P 500 was valued under 10 times depressed earnings. But, we changed for the better after Volcker’s 1982 lavage rapide. General Motors even closed down their cafeteria on the second floor of the General Motors Building. I miss their delicious egg omelets. Chrysler was bailed out in 1982, GM in 2009. Took many billions.

A century of financial stats shows even if you come in at the top of a cycle, if you stick invested for at least a decade, your rate of return can at least exceed Treasury bills and bonds. The money management business as practiced by our major banks and brokerage houses is based on this premise. Trot out the old 60/40 pie chart ratio for stocks and bonds. Right now, it’s not working. Passive investors still could lose serious money wedded to this construct.

The Dow Jones Averages sank below 10,000 early in 2001, then based at 6,649 in 2009. Stocks, normally twice as volatile as bonds, suggest an equity risk premium of zero is foolishly optimistic except when interest rates are minimal and the perception is they can stay down for years to come.

Let’s recollect, shoeshine boys didn’t find wherewithal to re-leverage themselves post the 1929 crash. Financial markets rested in deep depression for a decade. It took the onset of World War II to affirm the industrial might of the country. My starting salary on Wall Street in 1959 was 100 bucks, weekly. I was told to get an MBA and buy a pair of black shoes with shoelaces. Until then I wore Mexican huaraches.

You are what you do. I’ve serious assets in 2-year Treasuries. My biggest equity sector weighting is in energy. Namely, Exxon Mobil, Occidental Petroleum, Hess, Enterprise Products Partners and Williams Companies. If you pushed me to project the course of oil futures next 12 months, I’d shrug my shoulders and say: “Who knows, nobody knows.”

I am saddled with a long memory for market cycles. Does anybody but me remember in the autumn of 1974 the market had lost 30% of its valuation for the year? Only a handful of issues traded over $100 a share. The average stock on the Big Board sold closer to $25. Hundreds of issues had broken down into single digits. At one point the market had dropped over 50% from its high, and sold at $500 billion, which is much less than Apple goes for today along with Microsoft and Alphabet. All now sell in the trillions. Tesla ticked over a trillion bucks little more than a year ago, dropped closer to $700 billion before its rally to $900 billion currently.

In the horrendous setting of 1974 stocks like Polaroid, Xerox and Kodak jitterbugged over 5%, hourly. They touched low ground not seen since market bottoms of 1970 and 1966. Such accelerated rates of change now witnessed in our current setting.

In the halcyon sixties we used to extrapolate dividends 5 years out to see if prospective yields would be competitive with the S&P’s average, then 3.5%. This kind of nonsense disappeared in the stop-and-go economy where AAA utility bonds yielded 10%. Forced common stock offerings took place below book value, thereby diluting earnings. For an unprecedented group of growth stocks, median valuation dropped from 46 to 17, even with few earnings foul-ups.

For money managers, their courage stood crushed.

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