Why now is the time to be buying equities

This is my first post and it is purposefully broad in nature. My macro view and resulting bullishness will color my stock-specific commentary so I thought this would be an appropriate starting point. Yes it is scary out there, but I'm a buyer.

Let me be clear, I think the economy is in bad shape and will get worse before it gets better. Americans have too much debt because the most recent bubble was in housing. As Americans reduce debt, consumer spending comes down which naturally impacts business health and spending. In short, deleveraging is a very serious problem and I don't wish to downplay it.

So why am I a buyer?

A lesson from options pricing

As most of you know, in the options market, volatility is a key determinant of the value of an option. If a trader thinks Boeing's stock will be incredibly volatile, they will be willing to pay more for a Boeing stock option because they are more likely to be able to exercise the option and make money. All else equal, the higher your expectation of volatility, the more an option is worth. In an example that will be a perfect segway to the equity markets, imagine you bought a call option on Boeing. At the time you bought it, implied volatility was very high given the union strike and 787 delays etc. A month later, the stock has gone up 10% but your option has not appreciated in value. Even after accounting for the decay as a result of passing time, you think the option should be worth more. Chances are volatility assumptions have come down as well. So even though you were right on the fundamental (stock price) the change in volatility kept you from making money.

Now lets jump to the equity markets. The parallel to volatility in equities is fear/uncertainty. When you buy a stock, you are buying an ownership stake in the companies net assets and future earnings. Of course we are talking about future earnings, so they are inherently uncertain. As uncertainty and fear go up, the price we will pay for a stock goes down.

For the market broadly, my thesis is that the level of uncertainty and fear about future earnings across the whole market is VERY high and that the uncertainty will diminish even as the economic news continues to be bad. Basically, as the economy continues to deteriorate, investors will actually become more confident that this is not the end of the world and it will just be another bad recession. The result will be a flat market over the next six months as the bad economic news is offset by less uncertainty about how bad it might get. This is based on anecdotal evidence as I have gauged the mood of portfolio managers and analysts over the last several months.

The out-of-favor asset class

Another lesson from history is that investors typically do not flock back to the asset class that most recently burned them. This point is less compelling because one could argue that the only asset class that has not burned investors recently is treasury bonds. Despite that, my argument is that equities have been out of favor since 2000. If you look at the Price/Forward Earnings ratio for the S&P 500 index, you will see that it has been falling since 2000. Even when the index itself was going up between 2003 and 2006, the trend in the multiple was down.

My interpretation is that investors have preferred other asset classes since 2000. Housing, commercial real estate, commodities, alternative investments, gold, treasuries have all been in favor recently and either have or will disappoint. My expectation is that as this recession plays out, uncertainty will fade and investors will decide it is time to own equities again. Corporate earnings are coming down dramatically, and the market multiple is very low due to uncertainty. I don't know if that jumps off the page at you like I hope it did, but that strikes me as a perfect time to be buying something; when valuations are low and the hurdle is being lowered.

Conclusion:

Split your dry powder into four slugs to be invested one at a time over the next six months. I expect a lot of mini rallies and retrenchments as my thesis plays out so try to buy when the markets are off at least 5% from a recent high. Don't try to buy at or below prior lows, because that is a recipe for missing the show.



Why might I be wrong (a couple unanswered questions in my mind)

I will spell this out in my next post, but in essence, I think we are living through the repercussions of a special case bubble. Americans used additional leverage to speculate on an asset that already accounts for the vast majority of household debt in normal times. See next post.

It is possible that we are entering a new long phase in which corporate profit margins shrink for a long time. Basically, labor may gain a share of economic output at the expense of corporate earnings. I will admit this is possible, but I don't have an opinion worth sharing and am not sure how to determine if it is likely.