Despite Volatility, Stocks Are a Good Deal

By Donald Luskin

WHILE IT'S BEEN a turbulent couple of weeks for stocks, the resiliency of the market in the face of rampant panic and pessimism has been very encouraging. That means two things.

First, at these prices, even though stocks are still near all-time highs, they are nevertheless bargain-priced. Second, the credit crisis that has triggered the recent volatility really isn't all that threatening.

First, let's look at value. The S&P 500 may be near all-time highs, but that only puts it approximately where it was at the last high, in the year 2000, a full seven years ago. Back then, aggregate annual earnings were about $479 billion. Today, with stocks at about the same price, earnings are $820 billion.

That's right. Today you get $820 billion in earnings for the same price you used to have to pay for $479 billion. OK, a lot of that may be just that stocks were overvalued in 2000. But with earnings 71% higher now compared to seven years ago, there's no case whatsoever that stocks are overvalued today.

I think they're undervalued. Those earnings just keep pouring in. Over the last year, S&P 500 earnings have grown 11.5%. The consensus estimate of analysts is that they will grow 13.3% over the coming year (and, by the way, the consensus estimate has been a very accurate forecast the last several years).

Now how about the crisis in credit markets triggered by the collapse of subprime lending? The real issue for markets here isn't whether there are losses in certain mortgage investments (although those losses could be considerable), or whether defaulting borrowers are thrown out of their houses (although some will be).

Though difficult for those who experience them directly, those are small adjustments in the grand scheme of things, and the economy can easily absorb them as part of its dynamic process.

The real risk is a systemic collapse of credit markets. I don't mean a waterfall of defaults, each one triggering a further default. I mean an overall loss of confidence. Freely flowing borrowing and lending is absolutely essential to any modern economy, and it is entirely built on confidence.

Not just confidence that loans will be repaid, but confidence in the structure of credit markets themselves — which have become very complicated in recent years. Credit markets today are dominated by extremely complex derivative securities.

It's no longer just a matter of "I'll loan you a thousand dollars, and you pay me back in two years plus 5% interest." The new derivatives allow the risk of lending money to be structured optimally and spread out among many different kinds of investors who have different needs and risk appetites.

It's all good. But their complexity is daunting, and in times of sudden change, that complexity can make it hard for market participants to know where they stand — and that leads to a loss of confidence.

Many subprime mortgages have been packaged in complex derivative securities called CDOs — collateralized debt obligations. A CDO issues shares to investors, and promises to pay interest and principal over time as a function of the performance of the mortgages it owns.

CDO investors buy different "tranches," or slices, of the same underlying security. One investor may choose a senior tranche, which has first claim on all the income from the underlying mortgages. Junior tranches are only paid when the senior tranches are satisfied first.

That means if some of the subprime mortgages in the CDO go into default, the investors with senior tranches will probably do just fine. But those holding junior tranches could lose everything.

When you hear news stories about how CDOs holding subprime mortgages were rated AAA — the highest investment-grade rating from the bond-rating agencies — it may seem absurd, but it really makes sense.

It's the senior tranches that are highly rated — not the subprime mortgages themselves — because those tranches are in a very strong position to get paid. Now with default rates higher than expected, the junior tranches are getting wiped out.

There's a lot of wailing from the speculators who bought those, especially those who did so on leverage. But the reality is that the major institutions who bought the senior tranches are going to do just fine.

But because these structures are so complex, and because they do not trade on organized markets, nobody really knows for sure where they stand. Am I a winner or a loser? If I'm a loser, how much have I lost? If I'm a winner — for now — how close am I to bearing losses in the future?

So the CDO market is frozen. Many billions of dollars of borrowing and lending flow through that market, so that means that the credit markets themselves are severely impaired.

The problem flows into a related form of security — the CLO, or collateralized loan obligation. They work the same way as CDOs, but instead of mortgages they hold corporate loans, such as the loans made to private-equity firms doing corporate buyouts. No subprime mortgages here — but the complexity of the CLO structure has everybody spooked.

Many billions of dollars committed to buyouts are now at risk because the CLO market has shut down. That puts major investment banks on the hook to come up with the money for the buyouts some other way — or put it up themselves. Failing that, they will have to pay billions in "break-up fees."

So it's a mess to be sure. But it's not a real mess — it's just a psychological mess. Investors have to get comfortable with where they stand, what their losses are, and what kind of risks they will be willing to bear in the future.

That's a totally different thing than a cascading wave of defaults that wipes everybody out one after another. That's simply not happening. That means that after a brief period of adjustment, investors and speculators will do what they do. They will invest and they will speculate.

The credit markets will ease up, with or without CDOs and CLOs (I strongly suspect it will be with them, not without them). Why? Simple greed — and greed is good. Investors invest and speculators speculate in order to make money.

There is money to be made in mortgage lending because people need mortgages — there will be lending. There is money to be made in financing corporate buyouts, because it's smart to do corporate buyouts — there will be financing.

Stocks will have to live with a little uncertainty, while we see just how "brief" this brief period of adjustment is. But the credit markets will repair themselves and stocks will be at new highs before you know it.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.