Monday, October 6, 2008

Stock Market Fall

Today the Global Stock markets were beaten down followed by the U.S. Markets. Pundits are still claiming that the sell offs are in response to the liquidity crisis of confidence in the credit markets. After years of rising stock price that were way out of line with Price/Earnings (P/E)ratios could it just be reality setting in? Traditionally a reasonable P/E ratio was 7 times earnings before the stock markets were overrun with MBA's, derivatives and hedge funds. We then entered the age of "investing" wildly in companies that didn't have earnings and had little hope of posting earning in a reasonable time, yet the prices were driven up by speculation and anticipation. Suddenly investing was no longer calculated on trailing P/E rations but on projected (future) P/E ratios. This changed the whole dynamics of investing, stock prices became contingent on the future possibilities of a Company rather than on the current financial health and past performance of the Company. The loosening of margin requirements, the gambling of hedge funds and the advent of directives fueled the fires of wild speculation.

Directives were created at at abnormal pace and financial instruments were packed and resold in various pieces. These derivatives did not add value to any of the underlying instruments on which they were based but rather created another financial illusion. The fundamentals of the underlying values of the stocks are now emerging based upon real earnings not projections. The "Bailout/Rescue Plan" and the acceptance of it or lack of acceptance of it and the realization that this plan will have no discernible affect on the credit markets may be precipitating the seemingly unreasonable price swings.

The reality is that the stock markets were over valuing the price that would be reasonable to pay for a share of a company. Paying 87 times earnings is not a reasonable investment when the history of the Company shows you that their consistent growth is only 5%. The Markets might be approaching a "reality" based price instead of a "predictive price". The reality is that the Markets have been over priced for years and are now beginning to correct to an realistic level. Just as the upward spiral was over extended, so too the downside will go beyond that which is reasonable. If the real value of say the Dow Jones Industrial Average is 6500 based upon a P/E that follows trailing earnings, it will most likely be taken down 30% below that level, so we will see a downward draft that will be hard to stomach.

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