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I don’t know what news people are seeing that encourages them to buy stocks.  I meant to post this last night but didn’t get the time, so here goes.

The DJIA went up over 500 points yesterday and I’ll be damned if I can figure out why.  I kept an eye on the news headlines during the day, and here’s what they looked like at 2:45pm ET - just before the market skyrocketed into the close.  Here are the top headlines on MarketWatch.com as displayed by my “My Yahoo” page yesterday:

· Intel, H-P, Dell lead tech-sector losses - 14 minutes ago

· Citigroup looks for a new fall guy - 14 minutes ago

· Economic clouds could thwart some Obama energy promises - 14 minutes ago

· Energy stocks flirt with gains in volatile session - 14 minutes ago

· Chrysler’s survival difficult without government aid: CEO - 14 minutes ago

· GE shares fall back to 1996 levels on financing-cost concerns - 14 minutes ago

· U.S. stocks bounce back some after hitting new lows - 14 minutes ago

· Shares of Citigroup, Bank of America sink to decade-plus lows - 14 minutes ago

· Treasurys steady after 30-year bond auction - 14 minutes ago

· Gold dips below $700 as traders take more money off the table - 14 minutes ago

And here’s what the topr Reuters Business news were at the same time:

Jobless claims hit 25-year high, imports plunge - 1 hour ago

• The number of U.S. workers drawing jobless benefits hit a 25-year high this month and imports suffered a record fall in September, according to reports on Thursday that underscored a rapid drop-off in…

  · Stocks cut losses; energy offsets tech drag - 36 minutes ago

  Stocks cut losses on Thursday, sending the Dow and S&P 500 back briefly into positive territory, as investors scoured the market for beaten-down shares, including those of energy companies, offsetting…

  · Top hedge funds see more rules ahead for industry - 53 minutes ago

  Some of the world’s richest and most powerful hedge fund managers told U.S. lawmakers on Thursday that they support greater transparency for the secretive industry, but offered divergent views on …

  · GE shares tumble, company confirms 2009 dividend - 1 hour ago

  General Electric Co (GE.N) confirmed on Thursday it plans to pay a dividend through the end of 2009, but shares of the U.S. conglomerate remained down sharply.

  · Goldman suspends GM rating, Chrysler urges aid - 53 minutes ago

  Goldman Sachs suspended its rating on General Motors Corp on Thursday and said the automaker needs at least $22 billion in federal aid, while Chrysler said it would be “very difficult to survive&…

  · RIM co-CEO says market environment is “intense” - 50 minutes ago

  The current market environment is rife with challenges and requires careful planning of strategy, the co-CEO of Research In Motion (RIM.TO)(RIMM.O) said on Thursday as an analyst warned that sales of …

  · Citigroup board says supports its chairman - 39 minutes ago

  Citigroup Inc’s (C.N) board of directors said it supports its chairman and a newspaper report that said it was considering replacing him was “completely erroneous.”

  · Oil rises 4 percent on OPEC, equity market rebound - 9 minutes ago

  Oil jumped over 4 percent on Thursday as OPEC seemed poised to cut production again later this month and equity markets rebounded.

  · Lawmakers challenge big banks on bailout funds - 36 minutes ago

  Senators asked the nation’s biggest banks on Thursday to explain how they are using the billions of taxpayer dollars provided to them under a massive government bailout program. The answers were m…

  · Qualcomm halts UMB project, sees no major job cuts - 11 minutes ago

  Qualcomm Inc (QCOM.O), seeking to cut costs in the face of slowing demand for cell phones, has stopped developing a next-generation wireless technology called Ultra Mobile Broadband and is making smal…

There’s not a single bit of good news hitting the wires, but yet the market reverses course and ends up almost 1000 points higher than the low for the day.  Makes no sense to me, but I don’t see anyway investors can continue to ignore the news that says earnings are falling dramatically.  At some point the “P” needs to adjust to the dramatic drop we’re seeing in the “E” in order to bring the Price/Earnings ratio back in line.

gk

The DJIA dropped another 675 points today, bringing it down to 8579.  Exactly one year ago, it was at 14,164 - its’ all time high.  Aren’t you glad you pulled all your money out of the market last year?

What’s that you say?  You didn’t move to cash because you’re in this for the long term, you’re a buy and hold investor?  Oops!

According to a story on CNN.com today, “We are in a free fall right now and fundamentals have been thrown out the window,” said Phil Orlando, chief equity market strategist at Federated Investors.

Ummm….  Wrong.  The “fundamentals” have NOT been thrown out the window Mr. Orlando - the fundamentals are what’s causing the drop.  We’re at the start of the 3rd quarter earnings season, and there’s no doubt that earnings will be drastically lower than Q3 of 07.

So stock prices HAVE to adjust to keep the price earnings ratio reasonable.  I guess the only question is how low earnings will be - which will tell us how low the stock prices will go.

With the latest drop, the S&P 500 is at a PE of about 12 - which is right about the long term mean.  We’ve been way above that for a long time, so I expect to see the PE “revert to the mean” long term, which means we need to go below a PE of 12 for awhile.  Possibly as low as 8 - which is what the ratio was back in the early 70’s and the great depression.

So, how low can we go?  Let me know if you have a guess.  I’m guessing maybe 7500?  But that’s just a guess.

gk

Wow, lots of stories today about the “shocking” earnings miss (and lowered forecast) by GE.  MarketWatch said “GE’s warning pokes hole in recent sentiment that credit crunch has passed” and “The rebound had been fueled by renewed sentiment on Wall Street that the worst of the credit crisis — including the threat of spiraling financial bankruptcies — was past.”

A story on CNN said “My guess is that earnings forecasts for 2008 are still pretty high relative to the economic reality,” Davidson said.

I have one word for Mr. Davidson - Duh!

As I posted just yesterday, I don’t think we’re anywhere close to a bottom yet, and the earnings estimates for 2008 and 2009 are way too high.  Eventually, stock prices adjust to reflect earnings, and sometimes the adjustment process is long and painful - as we all learned in 2000 through 2003.

All the stories about Goldman Sachs’ and Lehman CEO’s saying that they can see the light at the end of the tunnel - while simultaneously upping their own writedowns - are crap.  If the CEO’s are so good at predicting the future, why couldn’t they tell us what losses their own companies were going to have?

Speaking of Goldman, I think the glitter is coming off.  This past week they announced that the amount of “Level 3 assets” increased from $69 billion to $96 billion during the first quarter.  If you haven’t been keeping score, “level 3″ assets are those for which there’s basically no market, no one wants them, so Goldman is stuck with them. 

Kinda like having a house that’s “worth” $1 million, but no one will buy it, so you’re stuck with the mortgage payments - but you can say you have a $1 million house.  At least until you have to sell it because you can’t make the payments any longer - then it suddenly becomes a $500k house - and you just lost $500k.

It also means that the value of those assets is a 100% guess.  In effect, Goldman is saying “we think we might have $96 billion in assets, but we really don’t know what they’d be worth if we tried to sell them.  They might be worth $96 billion (but we’re almost certain that that’s not right) but they might be worth 3 cents on the dollar.  We don’t have a clue, so we pulled that $96 billion number out of our butt.”

Level 3 assets are, by definition, “hard to value”.  In fact, they are impossible to value, because no one will buy them.  So companies use a “mark to model” method to come up with a number.  And since “mark to model” varies depending on the model used, we’re back where we started - no one has any idea what these assets are worth.

You may be asking why it’s a bad thing that the value of the assets rose so much in one quarter, and that’s a good question.  Wouldn’t it be a good thing if my $1 million house went up to $1.5 million in one quarter?   The answer to why it’s bad is that it’s a made up number.  I know that this is probably getting old but you need to understand it - NO ONE WILL BUY IT AT ANY PRICE RIGHT NOW!

Your next question is probably something like “why would they make up a higher number for these assets if that’s viewed as a negative?  Another good question, but the answer is easy.  You see, if you claim that your assets are worth more, you can use them as collateral so you can borrow more money.

Kinda neat isn’t it?  Goldman increased its’ ability to borrow by $27 billion in just one quarter.  But who would take these level 3 assets as collateral you ask?  You’re on your “A” game tonight dear reader - another good question.

The answer is that there’s only one place to go to borrow against these assets that no one will buy - the Fed.  You and me (via the government) are loaning Goldman billions of dollars by allowing them to give (I’m going to make up some numbers here - let’s call them “level 3″ numbers) the Fed $10 billion in level 3 assets.  In exchange, the Fed give Goldman $10 billion in Treasuries.

So you and I are now on the hook for $10 billion of basically worthless assets, while Goldman now has $10 billion of nice safe Treasuries.  Nice trick ain’t it?  That’s the Federal Reserve’s new Term Securities Lending Facility (TSLF) in a nutshell.

That’s one of the ways that the Fed is propping up the banks and brokerage houses right now - short of an indirect buyout like they did with Bear Stearns anyway.  But sooner or later, the losses from these made up level 3 assets need to be accounted for. 

The only question remaining is who will pay for the losses - the banks who made the risky loans, the investment houses that took the risky loans and leveraged them, or the taxpayer.  My best level 3 guess is that we’ll see a combination of the above, but taxpayers will eat a significant chunk of the losses.

As a result, the Fed will have to print more money to pay the bills, so the dollar will continue to fall, and the stock market will drop in inflation adjusted terms - and quite probably in real terms as well.  Within the next 12 months, Dow 9,000 is much more likely than Dow 15,000 in my opinion.

gk

I was reading an article on CNN tonight and happened to see these lines:

But sentiment seems to be shifting as of late.

“It’s still too early to tell,” said Thomas Nyheim, portfolio manager at Christiana Bank & Trust. “But I do think that when you have Ben Bernanke, the IMF, and all these strategists saying we are in a recession or about to see one, and the market doesn’t sell off much, that tells you something.”

I agree that sentiment is shifting - how else do you explain the stock markets’ reluctance to go down in the face of all the bad news?  It’s certainly possible that we’re “climbing a wall of worry” and that the short downturn in stocks is over - but I don’t think so.

There is too much optimism for me right now.  It seems that no matter how bad the news is, the stocks affected rally.  It’s like investors are thinking “At last, this is everything.  It’s all out there now.  Things can’t possibly get any worse, so there’s nowhere to go but up.”

I hate to be the bearer of bad news, but yes Virginia, things can get worse.  And I think they will. 

I’ve been playing with an Excel spreadsheet of earnings from Standard and Poors website.  Their 2007 estimate of $82.54 was high (actual was $70.83) and I think their 2008 estimate of $96.74 is way too high - by at least $20.

In other words, official estimates are looking for 2008 earnings to be HIGHER than the 2007 results.  I don’t think there’s anyway that’s going to happen.  The first quarter results will be a lot lower than last year (overall) and we are still in the early stages of the massive deleveraging that needs to happen as the housing market gets worse.

Stocks might be higher a month from now - but I doubt it.  They might be higher 6 months from now, but I doubt that too.  Unless there’s a massive (1500 to 2000 point) correction in the DJIA between now and then, stocks will continue to trade in the 12800 to 12200 range.

We may go down slowly, or we may see a huge two or three day slide, but stocks WILL eventually correct to reflect the earnings.  I’m just sitting on the sidelines waiting for that to happen.  If it doesn’t happen (I’ll be very surprised!) I’ll get back into the market when the 75 day EMA crosses over the 200 day EMA.  And we’re nowhere close to that happening.

gk