Tuesday, January 8, 2008

Preserving capital will soon direct investment decisions

After today’s market action, the Dow and the S&P are back to 12/06 levels and th NASDAQ is only slightly above its ’06 level. Investors have finally started to come to grips with the strong possibility of a recession and ratcheted stocks down violently the past few days. Markets don’t move in a straight line so there is time to lighten up positions at better prices when we see a bounce back. But I suggest becoming defensive if you already aren’t.

The earnings yield is the reciprocol of the P/E. If you divide the eps by the share price you get a stock’s earnings yield. A 20 P/E is a 5% earnings yield. If that yield is higher than say the 10 year treasury, you are getting paid to take the additional risk of investing in the stock vs. the safety of the bond. We’ve been in that situation for quite awhile. It’s about to change.

Inflation is here and just as investors finally acknowledged the possibility of a recession, they will soon acknowledge the fact that “core inflation” is an academic exercize and real inflation has been building at a rapid pace. Inflation will cause higher bond rates making the earniings yield unattractive which will result in P/E’s lowering.

Additionally, treasuries have been a safty haven, but that may change as the U.S. economy enters recession. If inflation and recession coincide we could see a strong downward move as bond rates dictate even higher stock earnings yields. That means lower P/E’s leading to lower stock prices.

All sectors will not be treated equally, so pick your stocks carefully.

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