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High Margin of Error
By Bill Bonner | Published  09/6/2007 | Currency , Futures , Options , Stocks | Unrated
High Margin of Error

All is well.”

Investors are being told that they have a great opportunity before them – because, the market has ‘bottomed out,’ and stocks are the cheapest they’ve been for 12 years.

As to the first proposition, they point to the stock indices. And it is true, after falling nearly 10% after July 19th, the indices seemed to find their feet in August...and have been gaining ground ever since. Of course, if our memory is correct, this is not the first time the stock market was shaken in the summer. It happened in the late ’20s too. And then, investors recovered their nerves, stocks rose...and later collapsed in the fall.

Optimistic voices continued to say that the tumble was very temporary...and that these lower prices created a great buying opportunity. But stocks sank...and sank...and sank...and didn’t return to their ’29 high until the 1950s!

Yesterday, the Dow fell 143 points. The day before, it went up. Which direction will it go tomorrow? If we only knew!

Also, the dollar is down this morning, against most major currencies...but guess what’s up? Our favorite precious metal...

“Warren Buffett, investor extraordinaire, offers two ways for you to protect your purchasing power against a weakening dollar,” our friend Chris Mayer tells us. “The first is your own earnings power. The second is ownership in a wonderful business, which an individual investor can get by holding onto great stocks. A stock is, after all, a share of ownership in a business.”

Which brings us back to the second proposition – that stocks are cheap – deserves more comment. Stock prices, generally, are about where they were eight years ago. For all his risk and trouble, the average stock market investor has almost certainly lost money – after commissions and inflation – over that period. Still, corporate earnings have gone up – for the various reasons we have discussed in these reckonings.

Without once again examining the unreliable and perverse nature of these increased earnings, we merely note that higher margins may be a good reason to pay more for a single company, but not for an entire market. In a single company, higher margins may reflect efficiency, good management, or a near-monopoly franchise.

“While I have nothing against owning gold or silver - in fact, I think it's good to own some - it's also helpful to think about solving the problem of dollar erosion more creatively,” continues Chris. “In the stock market, you can own many great companies with valuable tangible assets that will probably be worth much more in the future than today.”

But when looking at the entire market, not just a single company, high margins are always followed by low margins. Competition, increased output, and higher costs inevitably reduce the gap between revenue and expenses.

The news is full of encouraging words about how stocks on the S&P are the cheapest – in P/E terms – they’ve been since ’95. Still, they are trading at nearly 17 times earnings. That may be relatively cheap...but it’s not absolutely cheap. At genuine market bottoms stocks sell for as little as eight...or even five...times earnings. We have a long way to go before we get there. And getting there will be especially painful, because margins will fall along with prices. In the coming slump, companies will have lower sales...and lower margins. As the denominator of the P/E ratio falls...the nominator will have to fall even more to keep up with it.

Not that we know what direction stocks will go in the near term. Even Richard Russell thinks we are in a bull market that will carry prices considerably higher before the collapse comes. Maybe he is right. But anyone who buys stocks because he thinks we are at a real ‘bottom’...or that stocks are ‘cheap’...probably works on Wall Street.

Home sales fell more than expected in July. Much more. And the financial media is full of opinions about it. Some say the housing crisis has been discounted. Others think it will be much worse than analysts think.

How bad it will be, we don’t know. But it is surely a long way from being over. Next month, a peak in ARM adjustments for 2007 will be reached. Then, in March of 2008, the ultimate peak will come. This will mean as many as two million homeowners with substantially higher monthly payments to make – and a mortgage industry unable to bail them out by refinancing their homes. Fifty mortgage lenders have already closed their doors. Others have turned cautious.

House prices nationwide, says Jeremy Grantham in Fortune Magazine, are pushing six times family income. Ultimately, after the speculation fever subsides, families have to be able to pay for their lodgings. And historically, they’ve been able to do so at house prices of no more than four times family income. House prices are coming down, he says.

When house prices come down, it sets off a whole chain reaction of explosions – in the financial industry...the homebuilding industry...the retail industry...and ultimately, even the manufacturing sector! The result is recession...lower consumer spending...lower asset prices...less speculation...more fear/less greed.

Is that a bad thing?

“Sometimes it sounds as though you WANT stocks to crash...it sounds as though you’d be happy if a recession were to hit,” writes a concerned Dear Reader. “Isn’t that a little mean spirited?”

Yes, we would like to see a real crash on Wall Street. And yes, we would like to see a real recession. Is that mean spirited? Not at all. Au contraire, it comes from the deepest, most public-minded, most generous impulses of our entire idealistic nature.

This boom is a fraud, we keep saying. The sooner it ends, the better. It is a fraud because it is not based – at least not in America – on greater output, capital formation or wealth creation. Instead, it is a wealth destroying boom...one that rests on consumption, speculation and debt. Speculators and Wall Street itself get rich. But most people merely go deeper in debt...and become poorer.

What’s worse, the longer this humbug boom goes on, the more popular attitudes and habits are shaped by it. “Prices always go up,” say the lumpen, “so buy now.” “You can’t go wrong in stocks and real estate,” say the turnips. “A nice young man just offered to refinance our house,” say the homeowners. “Don’t worry...Ben Bernanke is not going to let us lose money,” say the speculators. “Deficits don’t matter,” says the Vice President.

Corrections, like revolutions, confessions and forest fires, are unpleasant. But they are often necessary. They clear away the dead wood.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.