The late value investing legend John Templeton used to say that the best time to buy is at the point of maximum pessimism. And he acted on that belief. In 1939, after 10 years of an economic depression and with war looming, Templeton bought $100 worth of every stock selling for less than $1 a share. He achieved 300% returns on that investment in four years.
Perhaps Templeton would be warming up his buying gloves right now.
Or maybe not.
The collapse in the housing market kicked off this crisis, and there are some reasons to believe that we're near or past the halfway point in the decline. Though it's risky to make generalizations based on monthly trends in a seasonable industry, on a month-to-month basis, the rate of decline of the Case-Schiller housing price index is slowing.
What's more, the real estate market is finally starting approach its fundamental value. Just as the value of a stock is a function of its discounted cash flow, the economic value of a house can be reasonably approximated by discounted cash flow that could be generated from renting that house. One would expect the ratio between the Case-Schiller Index and the Owners' Equivalent Rent -- the amount of money that homeowners would pay if they rented their houses instead of owning -- to remain roughly constant.
Indeed, from 1986 to 2000, this ratio fluctuated in a narrow range roughly between 1.1 and 0.9. When the housing bubble started inflating in 2000, the ratio began its ascent and eventually peaked above 1.6. Since then, the ratio has fallen to about 1.3. So, assuming a "fair" ratio is around 1.0, we're more than halfway to our destination.
But even a recovery in real estate prices wouldn't solve this crisis, because the writedowns plaguing Washington Mutual (NYSE: WM) and most other banks have shown few signs of abating.
In the first half of 2008, we had four bank failures, more than in all of 2007. Since the beginning of July, four more have collapsed, including IndyMac, which represented the second-largest bank failure in U.S. history. Still, enduring eight bankruptcies is minor compared with the hundreds of thrifts that went under during the savings-and-loan crisis of the late 1980s, so this trend may have only just begun.
Nor is the market for mortgage-backed securities recovering -- it may actually be worsening. According to JPMorgan Chase (NYSE: JPM) the mortgage market has "substantially deteriorated" even since July. This turmoil has caused banks to tighten their lending standards, and doing so has made it more difficult for businesses and individuals to get loans. It's also putting a drag on the economy.
Don't expect government-sponsored enterprises Fannie Mae (NYSE: FNM) and Freddie Mac to pick up the slack by issuing new loans. In a recent survey by The Wall Street Journal, economists estimated that there was a 59% chance that the government will need to bail out one of these companies.
The problems have spread beyond real estate and financials into the broader economy. The unemployment rate is at 5.7% -- the highest it's been in four years -- and rising. As you'd expect during a credit contraction and a faltering job market, consumer confidence had descended to extremely low levels.
Even major consumer-facing companies have been affected. Retailers from Target (NYSE: TGT) to Limited Brands (NYSE: LTD) are suffering declining same-store sales. Google (Nasdaq: GOOG) missed earnings estimates last quarter, with the company's CEO noting that the economic environment has become more challenging. Starbucks (Nasdaq: SBUX) has had to scale back growth plans and even close some of its existing stores.
In normal times, this is where you'd expect the Federal Reserve to jump in and come to the rescue. But by keeping rates too low for too long and ignoring all of the warning signs, the Fed helped fuel the speculative borrowing that caused this crisis. Now, with inflation running at 5.6%, the highest rate since 1990, the Fed's traditional method of addressing the problem -- reducing interest rates -- could make things worse by further weakening the dollar and aggravating inflation.
Does it do nothing and risk more bank failures, higher unemployment, and a run on the dollar? Or does it lower rates to stimulate the economy but risk higher oil and food prices and the creeping destruction of wealth through inflation? At this point, it looks as though Alan Greenspan's smartest move was retiring before his chickens came home to roost.
Fill your glass
Luckily, you don't need to figure out how to save the economy. You just need to find great stocks. On one hand, all of this bad news makes that job harder -- we almost certainly haven't seen the end of corporate bankruptcies, so it's important to avoid blow-ups. On the other hand, it's now quite possible to find companies with huge competitive advantages trading at excellent prices.
Thus, you shouldn't abandon the market, but your focus should change slightly. For example, earnings are less important in this environment than balance-sheet strength. In turbulent times, a strong balance sheet both ensures survival and allows a business to gain market share when the competition falters. When the recovery finally arrives, the strongest companies will have become even stronger, and profits will follow.