Extensive experience has taught me that there are many ways to be wrong about the markets: through shortsightedness, of course, but also through excessive farsightedness; through pride, ignorance, bad luck, impatience, imagination or sophistry.
—Jim Grant, Minding Mr. Market: Ten Years on Wall Street With Grant's Interest Rate Observer
The crowd almost always outsmarts the remnants (except at inflection points). It is human nature to feel most comfortable being part of a herd.
I prefer a different path—the path of a contrarian. This voyage holds risks but also provides rewards if one exercises strong analysis and patience.
A very good example of my contrarian streak is my bearish case for Apple in September 2012, when the investing world was universally bullish on the stock at $700 a share. The shares eventually dropped to under $400 a share in the months ahead. Another example given in this chapter is my reasoning as to why shorting bonds might prove to be the investment of the decade.
Read on.
Phew, I am now relieved!
I am comforted in the knowledge that on Tuesday a CNBC poll revealed that 90% of Wall Street economists believe that the recession has ended and that a Bloomberg survey (also this week) showed that the consensus sees real U.S. gross domestic product (GDP) expanding at annual rate of at least 2% for the next four quarters.
That's the same group of economists who failed to recognize the consequences of a bubble in stock prices in 1998–2000, the meaning of a three standard deviation event in rising home prices (and affordability), the fallout from a bubble in credit, the broad ramifications of a derivative market gone wild and an imminent recession several years ago.
And that's the same group of economists who interpret a statistical recovery as a self-sustaining economy that is incapable of double-dipping under the influence of numerous nontraditional headwinds.
The economists' conclusions must also be comforting to those Americans without jobs who don't count as unemployed because they have been dropped from the labor force and all the people getting foreclosed on in a housing market that has bottomed.
Yesterday's retail release was punk, though the markets again ignored it. Consumption remains weak, even with savings at lower levels than many feared at only 4% to 5%. I have wondered what is the downside to cost-cutting and productivity gains as the paradox of thrift (and its implications) could haunt us in 2010. One also has to wonder how far into the inventory restocking process we stand, as jobs, income, and consumption continue to move in a southerly direction. And one has to wonder what the downside to productivity is and how large the permanent reduction in employment will be as companies begin to realize that they can run on less.
Those surveyed economists apparently don't recognize the abnormality of the last cycle's leveraged and credit drivers, which occurred amid weakened job and income growth, and that their conclusion that the U.S. economy faces a normal or routine recovery seems more of a wish than reality (even in spite of the magnitude of the monetary/fiscal stimulation).
With the earnings-reporting period almost over, the cheerleading surrounding such a great earnings season has reached a crescendo, but in reality, with so many companies missing their sales guidance, there was not, as Gertrude Stein once said, all that much there there. The paradox of earnings is that an economy cannot cut its way to prosperity. From my perch, a more objective middle-ground reaction is necessary.
While the market participants once again wear their rose-colored glasses, the current conditions reading shows pretty clearly that, nine months after it happened, CEOs absolutely feel worse than they did in the immediate aftermath of the Lehman debacle. For instance, confidence among CEOs weakened to 63.0 in July from 74.3 a month earlier, according to Chief Executive magazine's CEO Confidence Index, which surveys 266 executives.
In the current bull market for complacency and cheerleading, investors are increasingly embracing almost any news in a positive if not promotional manner. Speculation, which always sows the seeds to its own destruction, is all too obvious, as there are more day traders and as IPOs triple and quadruple on their opening trades, which is all too reminiscent of the U.S. equity market in the late 1990s.
Back in early March, there were signs of a second derivative U.S. economic recovery, the PMI in China had recorded two consecutive months of advances, domestic retail sales had stabilized, housing affordability was hitting multi-decade highs (with the cost of home ownership vs. renting returning back to 2000 levels), valuations were stretched to the downside and sentiment was negative to the extreme. These factors were ignored, however, and the S&P 500 sank below 700.
To most investors, back in early March, the fear of being out was eclipsed by the fear of being in. Despite the developing less worse factors listed above, bulls were scarce to nonexistent in the face of persistent erosion in equity and credit prices.
It was at this point in time that I confidently forecast the likelihood that a generational low had been reached.
I went on to audaciously predict that the S&P would rise to 1,050, a gain of nearly 400 points from the S&P low of 666 during the first week of March, by late summer/early fall. I even sketched a precision-like SPDR S&P 500 ETF (SPY) trajectory that would reach approximately the $105 level (a 1,050 S&P equivalent) within about six months.
Yesterday, the SPY peaked at 104.20, within spitting range of my intrepid March forecast of 105, and the S&P nearly touched 1,040 in Tuesday's early-morning trading.
Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations, and positive sentiment.
To most investors, today the fear of being in has now been eclipsed by the fear of being out, as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices.
As if the movie is now being shown in reverse, the bull is persistent, stock corrections are remarkably shallow, cash reserves at mutual funds have been depleted, and hedge funds hold their highest net long positions in many moons.
Stated simply, in the current bull market in complacency, optimism, and a boisterous enthusiasm reigns.
The investment debate has morphed in a dramatic fashion from concerns as to whether U.S. economy was entering the Great Depression II to whether the current domestic recovery will be self-sustaining.
The primary question to be asked is: Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world's economies, particularly as the public-sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public-sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?
Most now have accepted the notion that due to the replenishment of historically low inventories, extraordinary fiscal/monetary stimulation and the productivity gains from draconian corporate cost cutting, the earnings cycle is so strong that it will trump the consequences of policy. More accurately, most believe that they can get out of the market before the full effects of policy are felt.
I am less confident, as a decade of hocus-pocus borrowing and lending and 35-to-1 leverage at almost every level in both private and public sectors cannot likely be relieved in the great debt unwind over the course of only 12 months.
It is important to emphasize that when I made my variant March call, I expected many of the conditions that now exist—namely, a resurgence of economic and investment optimism during the summer to be followed by a multiyear period of weak investment returns. Specifically, I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.
My view remains that it is different this time. Again (now for emphasis), the typical self-sustaining economic recovery of the past will not be repeated in the immediate future.
Just as I looked over the valley in March 2009 toward the positive effects of massive monetary/fiscal stimulation within the framework of a downside overshoot in valuations and remarkably negative sentiment, I now suggest another contrarian view is appropriate, as I look over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed.
Yesterday, the Office of Management and Budget/Congressional Budget Office provided an exclamation point to the secular challenges that the domestic economy faces in forecasting an accumulated deficit of $9 trillion over the next decade (up $2 trillion from the previous forecast just two months ago), and public debt as a percentage of GDP is projected at an alarming 68% by 2019 (as compared to 54% today and only 33% in 2001). Thus far, the drop in the U.S. dollar (influenced, in part, by the mushrooming deficit) has been viewed favorably by the markets, but we must now be alert to a downside probe that becomes a threatening market factor. In other words, what has been viewed positively could shortly become negatively viewed.
A double-dip outcome in 2010 represents my baseline expectation. When the stimulus provided by the public sector is finally abandoned, it seems unlikely to be replaced by meaningful strength or participation by any specific component of the private sector, and the burgeoning deficit will ultimately require a reversal of policy, leading to higher interest rates, rising marginal tax rates and a lower U.S. dollar. My forecast assumes that the market's focus will shortly shift from the productivity gains that have been yielding better-than-expected bottom-line results toward these chronic and secular worries.
Even more important, my forecast of a 2010 market peak reflects that the aforementioned nontraditional influences (and the untoward policy ramifications) will, at the very least, yield a broad set of uncertain economic outcomes that (in consequence and in probability) tilt away from a self-sustaining economic scenario sometime in the following 12 months.
Stocks bottom during times of fear. With the benefit of hindsight, the March 2009 lows represented a dramatic overshoot to the downside.
Markets top during times of enthusiasm. I believe that the markets are now overshooting to the upside and that the U.S. stock market has likely peaked for the year.
“It is the mark of an instructed mind to rest satisfied with the degree of precision to which the nature of the subject admits and not to seek exactness when only an approximation of the truth is possible.”
—Aristotle
This column will address top-down market valuation, explain why I believe the price-to-earnings (P/E) multiple expansion beginning six months ago appears to be coming to an end and then go on to recap the forces that make me more bearish on corporate profits vis-à-vis the emerging and more bullish consensus.
Given that the First Call total of S&P operating earnings for the first half of this year was about $30.50 a share and is estimated at $15 a share for the third quarter ending September 30, 2009, it is safe to say that 2009 S&P operating profits will approximate $62 a share. First Call consensus S&P earnings forecasts for 2010 now run around $72 to $74 a share, for a gain of almost 18% year over year.
Many strategists (both bullish and bearish) assume that a fair value price-to-earnings multiple—based on interest rates and inflation—rests at about 15.5. Averaging the 2009 and 2010 S&P consensus forecasts produces a melded $67.50 S&P earnings per share (EPS), a year-end target of 1,045 and a mid-2010 S&P target of 1,130 on EPS of $73. (The current S&P level is 1,043.)
Bearish strategists such as David Rosenberg believe the current S&P level is discounting a 40% increase in 2010 earnings over 2009, but the consensus believes that about 10% growth is being discounted.
Bearish strategists expect real GDP growth of about 1% to 2% next year, but the consensus now anticipates 3% to 3.5% growth in 2010.
The market's P/E multiple is up by 5.5 points, or more than 40%, since equities bottomed in early March. So, even for the bullish strategists, the phase during which expanding P/E multiples contribute to the market's advance is largely over, and future stock market gains will be dependent on the achievability of a healthy growth in S&P operating earnings toward the consensus.
“In poker terms, the Treasury and Fed have gone ‘all in.’ Economic medicine that was previously meted out by the cupful (pumping dollars into the economy) has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation.”
—Charles Munger, Berkshire Hathaway
Stated simply, my argument is that the earnings expectations for 2010—the level and growth rate—will disappoint, and the expectation of disappointment has brought the market into overvalued ground.
Let's assume we can all agree that the full extent of the P/E expansion phase is about over and that further market gains will rely on the realization of the optimists' baseline expectation of relatively smooth and solid earnings growth for 2009–2011. Even on the consensus expectations, the market appears to be fairly valued now and somewhat undervalued (by about 9%) on a 12-month forward earnings basis.
While I accept that the baseline consensus expectation of S&P 2010 EPS of $73 a share is a possible and logical outcome, a double-dip would not be illogical considering the economic, credit and equity markets' heart attack. I would argue that there exists a wider range of economic and profit outcomes than is customary during a recovery phase, and that the certainty associated with today's consensus of a positive outcome could be tested.
There is always the need for rigor in the analysis of the economy and profits. We know history rhymes and that we must rely on past relationships, even after adjusting for the new reality/reset to frame our views. But, to some degree, the same set of economic series and charts that failed to appreciate the historically unique and shaky foundation of credit-driven economic growth in 2002–2006 might be underestimating the economic consequences of the great unwind of credit, the ramifications of the massive policy decisions that were necessary to counteract the building recessionary conditions in 2008 and the unfolding of numerous nontraditional headwinds.
Jim Cramer says the bears are “ignoring the good news at their own peril.” I would argue that the bulls are ignoring the emergence of a number of secular headwinds. Here are 10 of them:
The liquidity that grew out of the massive government stimulation and the growth in the monetary base is reaching the equity market and our economy. It has been greeted by cheers and almost unnoticeable, brief and shallow pullbacks in stocks, producing a degree of price momentum that is almost reminiscent of the good old days in 1999/early 2000. Market participants appear now to have embraced the notion that we are in an economic sweet spot and that a below-average but self-sustaining domestic recovery is being endorsed.
With the perspective of the large market rise and dramatic change in sentiment (from dire to positive), there is now little room for disappointment.
Coming out of the last several recessions, aggregate economic activity moved quickly back to peak levels, but, consistent with the accepted shallow-recovery thesis, it won't be as quick to recover this time. David Rosenberg expresses in Barron's that the secular rise in credit expansion of the past several decades could be a thing of the past in the years ahead, producing a truly different experience this time. While we have to try, it's hard for me to be confident in the certainty and precision of a baseline view, especially within the context of the long and uncertain tail of all the nontraditional headwinds. With financial inventiveness being put on the back burner, unbridled, unregulated, and (sometimes) unsavory debt creation will no longer catalyze growth in a world where banks are reluctant to lend, the securitization markets are broken and the shadow banking system is nearly extinct.
While it's fortunate that our financial institutions have reduced the chance of systemic risk by decreasing their balance sheet debt, the U.S. government has taken the banking industry's place. And with that come challenges anew over the next decade.
Berkshire Hathaway's Munger argued that those challenges and the bills associated with policy are being ignored—or investors believe they can get out before they come due.
The credit and stock markets have been buoyed and dominated by the better-than-expected earnings cycle. The replenishment of historically low inventories, the effects of recent and extraordinary fiscal/monetary stimulation, a recovery in residential housing activity and the productivity gains from draconian corporate cost-cutting are favored in influence by Jim Cramer (and others) and have clearly trumped the potentially negative consequences and those due bills of policy.
But stimulation is by definition bringing sales forward, and Policy (with a capital “P”!) has its consequences. Some programs have the potential for borrowing from 2010 to 2011; others, such as mortgage credits and even monetary policy, have a finite life to them. They end and the artificiality of the stimulative initiatives is lost—and the economy becomes demand-dependent. Given the past shock, it's hard to see a solid view of that demand.
Then there is the consumer, who remains particularly exposed in the period ahead. Private wages and salaries fell by a record 5.2% annualized rate in July. While some improvement from depressed levels can be expected, the labor market remains weak and jobless claims are still elevated. The possibility exists that the consumer will retreat from the decades-long aspirational spirit and turn back toward the legacy of the post-Depression mentality of maintaining the status quo. With this reset could come disappointing personal consumption expenditures and a higher level of savings that will likely match the post–World War II average savings rate of 7.5% and could even begin trending back toward the direction of double-digit savings rates that existed in the recession of the early 1980s.
In summary, the market has discounted favorable expectations and seems more certain of a self-sustaining recovery cycle outcome. Reflecting the gravity and weight of so many inhibiting factors, I see a much broader range of possible outcomes and less certainty than some of the newly printed bullish market participants.
The credit expansion of the last several decades has reversed, it will take time to reverse the damage to net worth and confidence, the consumer remains in a fragile state, corporations will make do with more productive but fewer personnel (job growth could continue to disappoint), there are no apparent drivers to replace the role of housing (2002–2006), and numerous nontraditional headwinds (most importantly higher marginal tax rates) will have an uncertain impact on aggregate growth.
Dave Letterman–style, below are the top 20 signs how bad the economy is:
And the number one sign how bad the economy is…
“The best investors are like socialites. They always know where the next party is going to be held. They arrive early and make sure that they depart well before the end, leaving the mob to swill the last tasteless dregs.”
—The Economist, 1986
I aggregate an annual surprise list because outlier events (black swans) are occurring with greater frequency, uncertainties will persist, and the conventional view is often wrong.
Markets are never black or white, and the investment mosaic is growing ever more complicated. While the determination of market prices and valuation will always be dominated by traditional factors (interest rates, inflation, corporate profit growth, etc.), markets have become far more nuanced and susceptible to disequilibrium in the aftermath of the unparalleled credit-driven boom and in light of complicated political issues and rising geopolitical risks that, arguably, have been all but ignored.
“I fall back on the analogy of a stalled car (the economy) being pulled by a tow truck (government stimulus). The tow truck will want to let the car down one of these days and go on its way. Will the car be able to move on its own? We can only wait and see. I think it's more likely to sputter along than it is to move forward energetically. But at least we don't have to worry any longer about the analogy of 15 months ago: an airplane whose engine has flamed out. A powerless plane in mid-flight presents a far more troubling image than a stalled car.”
—Howard Marks, Oaktree Capital Management (Tell Me I'm Wrong)
It can be argued as we exit January 2010 that the prices on Wall Street remain somewhat ahead of the conditions of Main Street. While the market rally has exceeded all expectations that existed during the first quarter of 2009, a year later we find an economy that is expanding but still heavily reliant on government stimulation—even despite a zero-interest-rate policy (ZIRP) and a lower U.S. dollar that promotes more robust exports.
The unemployment picture remains weak as corporations do without more workers, so the general welfare of the all-important consumer is not much improved. Small-business confidence and expansion plans are low because of tax, regulatory uncertainty and limited access to bank credit, so new hires are weak. In contrast to a weak consumer and frozen small business community, large corporations are prospering from draconian cost cuts (but not much top-line improvement), strong (cash-rich) balance sheets and an ability to obtain credit.
Whether the current market decline is a bump in the road, the end of the road or something in between can be debated. I would choose that the most likely short-term outlook is something in between a bump in and the end of the road. While I don't see last week's drop as the start of a meaningful correction in equities, I don't see much upside either. In other words, the short-term market might be disappointingly dull and range-bound, with a slight negative bias.
The election news in Massachusetts and strong corporate revenue and profits were ignored last week. The year-to-date decline in the S&P 500 is over 2%; a week ago the markets were up by over 3% year-to-date. Investors no longer seem complacent—the put/call ratio is rising after several distribution days—and there is an element of panic in the air. From Tuesday's top to now, we have dropped by nearly 5.5%. More important, many stocks have fallen much more from their recent tops to Friday's close: Just look at Caterpillar's drop of 10 points, to $54 a share, or the similar drop for IBM's shares. There are many other examples.
If last year was the time to ride the remarkable values that grew out of the late-2008/early-2009 financial and market panic, 2010 could be a year in which stock pickers (of both long and short ideas) and opportunistic traders deliver the best investment performance—it might also be a great year to sell premium, straddles and strangles.
It remains my view that the consensus forecasts for GDP, corporate profits, interest rates and for targets on the S&P 500 have a reasonably high probability of occurring but that a number of less benign outcomes remain possible. By the last half of this year, or in early 2011, the consensus forecast of a self-sustaining economic advance could be in jeopardy as there are many potential factors that could contribute to slowing growth. Accordingly, a fully invested position in stocks (which most strategists are recommending) should be questioned. From my perch, a relatively conservative posture seems more appropriate.
It is also my view that the markets have materially discounted improving macro conditions, and I am holding to my baseline expectation that 2010 will bring a high-single-digit negative return in the major market indices (down 5% to 10%). Valuations are not stretched. We'll likely see an extended period of zero-interest-rate policy (and a curse on cash by the Fed), relatively tame current inflation and inflationary expectations, and a strong year-over-year gain in corporate profits. Plus, as an asset class, investors have not embraced stocks in this cycle—mutual fund stock inflows are negligible. These are among the factors that should cushion the current market fall. The generational low of March 2009 remains very much intact.
Regardless of one's short-term view, the nontraditional challenges facing the capital markets are multiple. Most of these factors are valuation deflating, serving to cap the upside to the U.S. stock market in 2010 and argue against the view that we are embarking upon a normal 40-month-plus upcycle:
I have argued that among the most important challenges to the economy and the markets is a tidal wave of populism. The angry subtext and poor attitude toward big business and the wealthy has rarely been this bad.
We don't now know how this all pans out.
We don't know whether, after deteriorating approval ratings and the Massachusetts election upset, President Obama will move to a more centrist policy position.
We don't know how health care and energy reform will be written.
We do know that the depth of our country's fiscal problems could mean that gridlock and legislative inertia are bad this time for the capital markets.
We do know that there is a new sheriff in town for the Republicans as the newly appointed Senator from Massachusetts will likely replace Sarah Palin as an important spokesman, leader, and even potentially become the frontrunner for the Republican presidential candidacy in the next election.
The cause of a possible downside market move and the least benign outcome for the markets are clear.
When the policies of populism (higher taxes and more costly regulation) are mixed with a number of other nontraditional headwinds (municipalities' disarray, a still-wounded lending mechanism, etc.), the trajectory of economic growth will almost certainly be stunted. I believe these influences and policies could be reflected, contrary to consensus, in a weakening economy by the second half of 2010—one of the less benign outcomes I referred to earlier.
These two factors—(1) public policy that grows from populism; and (2) nontraditional headwinds—form a potentially toxic cocktail, especially within the context of the size of the market rally of the past eight months and under the possible setting in which higher interest rates begin to offer competition to stocks.
More than any other time in history, we exist in a global platform that has permitted more people to plug and play, collaborate and compete, share knowledge and share work. But, the hidden hand and interlinked nature of the markets and economies almost never work without a hidden fist. A world as one has an upside and a potential downside as we have witnessed throughout the recession and most recently concerning Greece's sovereign debt issue.
“If you don't visit the bad neighborhoods, the bad neighborhoods are going to visit you.”
—Thomas Friedman
Back in 2005, Thomas Friedman wrote the international bestselling book, The World Is Flat: A Brief History of the Twenty-First Century, which analyzed the trend in globalization in the early twenty-first century. The title was a metaphor for viewing the world as a level playing field in terms of commerce, where all competitors have an equal opportunity. The title also alludes to the perceptual shift required for countries, companies and individuals to remain competitive in a global market where historical and geographical divisions are becoming increasingly irrelevant.
It is abundantly clear that, over time, the world's markets and businesses have become increasingly connected and interdependent. With advances in telecommunications infrastructure and the rise of the Internet, the process has been accelerating rather dramatically over the past 15 years as technological and financial innovations make it much easier for people around the globe to communicate, to travel and to participate in international commerce.
“No man is an island, entire of itself…any man's death diminishes me, because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls for thee.”
—John Donne
Interconnectivity in a linked world is not a novel concept. For example, from your high school days, you might recall the quotation above from late-sixteenth/early-seventeenth-century English poet John Donne.
With the world growing smaller (and flatter), U.S. financial institutions have been especially active in smelling opportunities outside our country. Whether, as suggested in Sunday's New York Times, Goldman Sachs and other investment banks have exported the problems associated with financial derivatives or it was a by-product of the search for yield as interest rates dropped to historic lows, the fact remains that the proliferation of unwieldy and unregulated financial derivatives around the world deepened the economic downturn, and it continues to produce financial aftershocks with unknown consequences.
I believe that Greece will be resolved and, in all likelihood, the solution will not be terribly disruptive to our markets. The situation is manageable and should be put into perspective. The fiscal problems facing Greece will likely be bandaged over the next few months and, hopefully, will be resolved in the fullness of time through financial assistance, austerity and, ultimately, a more disciplined fiscal policy. Also, I believe that China's tightening was preemptive.
Nevertheless, we cannot paint over the far reach and potential problems associated with financial interconnectivity. My general feeling has been that many strategists are paying far too much attention to previous economic cycles (and traditional economic series) without fully recognizing the many new and nontraditional challenges to growth.
As Thomas Friedman wrote, most of our political elite don't understand that the world is flat, so the chances of policy mistakes loom larger.
Though our domestic fiscal problems are shallower than the problems over there, they still run deep. Contrary to the traditional view that gridlock is good for stocks, equities have been on the descent since Scott Brown's surprise Massachusetts Senate win.
The reasons for the weakness are multiple:
It remains different this time, as over here and over there become interchangeable. Austerity, from the states of California and New York to the countries of Greece and Spain, remains a common theme that will detract from growth.
I emphatically reject the notion of those who see the current cycle as no different than the previous ones—namely, one that is capable of dependable, smooth, self-sustaining and enduring growth. By contrast, I have argued (and continue to argue) that the aftershocks and deleveraging from the last steroid-aided credit cycle will have a long tail and will be with us for some time. The aftershocks will appear in numerous corners that will not only stunt economic growth but could produce headwinds to the benign consensus view of a shallow economic recovery. Under these circumstances, a lid is likely placed on P/E multiples.
In summary, we now must add the uncertainty of global connectivity (and the pesky critters that reside in dark and unknown corners) as a new influential factor to an already crowded list of unusual aftershocks that are byproducts of the earlier easy-money credit cycle:
While investors should continue to assign the highest probability to a benign and durable economic advance, a fine balance will be required to thread the needle and produce a smooth and self-sustaining world economic recovery. The foundation of growth remains shaky, and the risks of continued aftershocks and economically deflating policies (both in the United States and abroad) in a world so interconnected are simply too high to support a heavy commitment or above-average weighting to equities in 2010.
U.S. corporations have a renewed emphasis on temporary hirings at the expense of permanent job placements.
Years ago, inventory on-demand solutions arose at manufacturing companies around the world, resulting in improved returns on industrial invested capital and corporate profitability both in the United States and abroad.
Not surprisingly, today, the trend of a broader use of temporary workers is the next generation of return optimization in an age of broad uncertainty and a wider-than-usual set of economic outcomes.
Prior to the 2008–2009 Great Decession, temporary employment growth has signaled permanent hiring strength.
Out of the 1990 recession, temporary jobs first began consistent positive year-over-year growth in December 1991. Overall nonfarm employment turned positive four months later (April 1992).
Following the 2001 recession, the “jobless recovery” produced a sputtering in temporary job growth throughout all of 2002 and did not post positive percentage growth until mid-2003. Six months later, total employment exhibited year-over-year growth.
In the current recovery, temporary jobs crossed into the positive growth region in January 2010 and then surged into double-digit growth with gains of 19.4% in June, following year-over-year rises of 16.9% in May and April's 14.6%, but total nonfarm employment has yet to grow year over year, since the series first turned negative 26 months ago (May 2008). The job loss was under 1% in June, however, and total employment will likely cross into the year-over-year positive region soon. As of now, the lag is five months, still shorter than the six-month lag between temp jobs' and all jobs' year-over-year recovery in 2003. If the lead-lag relationship holds up this time, year-over-year U.S. job growth should become positive sometime in the second half of the year, but the growth will likely be modest relative to past cycles of employment growth.
In other words, a rise in cyclical unemployment appears to be morphing into structural unemployment in the United States.
We can trace a number of reasons behind the movement that favors temporary workers:
What are some of the ramifications of this new era of temporary job growth?
While, historically, the rise in temporary job growth signals a broader improvement in the employment markets, I am less certain in the current cycle and, for that matter, over the course of the next few years.
Economic bulls have been incorrectly predicting stronger jobs growth since fourth quarter 2009.
They have been disappointed and are likely to continue to be disappointed in the decade of the temporary worker.
“It is always darkest before the dawn.”
—Proverb
The perma-bulls (who generally missed the 2008–2009 bear market Great Decession), until recently have called for a “V”-shaped domestic economic recovery and have been targeting about 1,300 on the S&P 500 as their objective. Some strategists, like JPMorgan's well-regarded Tom Lee, remain steadfast in their views and are still holding on to this target despite the ambiguity of the current soft patch that has taken most perma-bulls by surprise.
By contrast, the perma-bears (who generally missed the near-60% upside move in stocks from the generational low and the sharp recovery in domestic GDP) have called for a double-dip in the U.S. economy and have been targeting about 900 on the S&P. Their mantra consists of “black crosses”; “Hindenburg omens”; and structural, fundamental, and nontraditional headwinds.
I think both camps are hyperbolic (the bears more than the bulls) and attention seeking, but their respective views will likely not provide investors with viable or profitable strategies.
The investment and economic truth likely lies somewhere in between.
The economic recovery will likely be uneven and inconsistent. At times it will appear that the economy is headed back into recession; at other times it will appear that the economy is reaccelerating its growth rate.
I expect the S&P 500 to trade between 1,020 and 1,150 (roughly between 11× and 13× 2011 S&P EPS forecasts).
While we can never have such precision, my forecast taken literally (at the current 1,075 level) indicates that there is approximately 55 S&P points of risk and about 75 S&P points of upside. In other words, the scale has now tipped back to the bullish side.
We are in this vortex of tax and regulatory traps. The uncertainty of policy has resulted in what can be viewed as a fiscal tightening and a paralysis of corporate indecision. Arguably, the continued weak series of economic releases over the past week increases the possibility that, by year-end, we will see a renewed sense of urgency from our politicians for policy relief from the tax and regulatory logjam.
A catalyst to a tipping point of changing fiscal policy could also occur as an outgrowth of a Republican win in November's elections, leading to a decision to continue the Bush tax cuts or even institute a payroll tax cut (or other outside-the-box initiative) in early 2011. (The market, as it usually does, will likely react positively in advance of these possibilities.)
In determining market levels—as I did in calling for a generational low in March 2009—the principal factors I use in establishing a fair market value and range for equities are economic fundamentals, interest rates, valuations, expectations and sentiment.
An easy Fed that is content to maintain a zero-interest-rate policy indefinitely, coupled with a cycle low in inventories, residential investment, automobile unit and capital spending sales relative to their long-term relationship to GDP and relative to their longer-term trends, argue strongly against a domestic double-dip. Moreover, an expected mean regression of these four series could provide important support for a moderate expansion in GDP growth in the years ahead.
In other words, the current soft patch indicates a moderating expansion but not a double-dip.
And history shows that that moderate economic growth typically produces positive investment returns. Since 1950, quarterly real GDP growth rates of 0% to 1% have produced a quarterly return in the S&P 500 of more than 2%. According to Miller Tabak's Dan Greenhaus:
Equity returns needn't be negative in a slow growth environment.…There's about a coin flip's chance of the S&P 500 being down in any given quarter in which GDP contracts. Viewed another way, 50% of the time the economy contracts in a given quarter, the S&P 500 increases in value and does so by more than 9%.
The low level of interest rates remains the single most compelling bullish argument for stocks—and there are many examples of a disconnect between stocks, interest rates and other metrics/markets of risk.
At under 12× 2010 estimates, equities seem inexpensive to a multidecade average of over 15× and at 17× when inflation is contained and interest rates are low.
Since 1962 the yield on the 10-year U.S. note has averaged about 365 basis points above the quarterly pace of real GDP growth. With the current 10-year yield of 2.58%, the fixed-income market is discounting negative real growth in the domestic economy.
As Omega Advisors' Lee Cooperman mentioned to me over the weekend, industrial companies are taking notice of the developing values—it is unlikely that BHP Billiton and Intel would propose spending $30 billion and $9 billion, respectively, for the acquisition of Potash and McAfee if they felt an economic apocalypse was on the horizon.
There is not a market participant extant who doesn't recognize that the slope of the recovery in the domestic economy will be different this time and that the ramifications of the administration's populist policy, the growing perception of a structural rise in U.S. unemployment, consumer deleveraging, concerns of deflation, the emergence of nontraditional (and intermediate-term) headwinds (e.g., fiscal imbalances, higher marginal tax rates, costly regulation, etc.) all will serve as a brake to domestic growth.
And what about the common view that the consumer is spent-up not pent-up? The bearish view that the consumer is the Achilles' heel to growth might be challenged.
Much like 17 months ago, we appear to be rapidly approaching a negative extreme in market and economic sentiment.
The hedge fund industry has derisked. Net long equity positions remain low by historic standards and, increasingly, hedge-hoggers such as Stan Druckenmiller are leaving the business.
To some degree, Stan's decision reflects how difficult it is to deliver superior investment returns in a world driven by the uncertainty of policy and economic/investment outcomes superimposed by the destabilizing effect of an algorithm-based world of short-term momentum strategies and, perhaps even more importantly, short-term-oriented investors. His decision reflects an investment world that has grown increasingly less predictable, and the ability to deliver superior investment returns has been challenged, in part by some of the factors mentioned above. We're in an environment in which portfolio managers and investors are dually frustrated. To many, it is getting to the point where “it's no fun anymore.”
Importantly, Stanley's exit yesterday is reminiscent of when value was out of favor and glittering hedge fund manager Julian Robertson quit in the early 2000s, so I suppose you can say that history rhymes. But remember, almost as soon as the ink dried and Julian closed shop, his beloved “value stocks” came back in vogue.
Such a shift could happen again, as a dysfunctional market moves back into a biased-to-the-upside trend—just at a time when some throw their hands up in the air in despair.
Also, retail investors have fled domestic equity funds in favor of yields in the bond market. Over the past year, there has been a record flow into bond funds compared to equity funds.
With the two dominant investor groups—hedge funds and retail investors—derisking, who is left to sell?
The U.S. stock market has already discounted a recession/double-dip. And the notion of secular headwinds has been recently adopted by the consensus and has contributed to a weak equity market.
Domestic economic and stock market expectations are low.
While a number of risk metrics and risk markets have improved, equities still lie near the bottom of a projected trading range.
Stocks are especially attractive relative to interest rates, and an extended period of underperformance against fixed income has soured both hedge funds and retail investors toward equities.
It is time to fade the growing negative consensus and adopt a variant view by becoming more constructive on stocks.
Bull markets are born out of distress—witness March 2009. Bear markets are born out of prosperity—witness 2007.
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
—Robert Frost, “The Road Not Taken”
Liquidating/derisking out of equities and acquiring/rerisking into fixed income has been the mantra of most individual and institutional investors over the course of the last three years. Since early 2008, retail investors have sold over $200 billion of domestic equity funds, while purchasing nearly $600 billion in fixed-income products. That gap of over $800 billion is unprecedented as is last decade's spread in performance of bonds vs. stocks the largest in history. But history tells us that the S&P 500 performs famously in the following decade and ultimately moves contra to a peak in flows.
I believe that it is time to take the road less traveled and to raise net long exposure at precisely the time when such a strategy is most unpopular.
In many ways, the sentiment toward equities today is as bad as the extreme experienced at the generational low 18 months ago. Indeed, at Tuesday's close, the market zeitgeist was eerily reminiscent of 1979 when BusinessWeek published its “Death of Equities” cover.
The fact is that most classes of investors now view U.S. stocks with distrust.
But who is left to sell, especially if the concerns regarding a double-dip prove unjustified?
I continue to view the double-dippers as on the wrong page.
Consider that the cyclical components of GDP, such as autos and housing, now contribute so little to aggregate GDP that the year-over-year impact in late 2010/early 2011 can only modestly impact output. Moreover, with inventories-to-sales so low and with auto and residential investments so far from their longer-term trendline relationship to GDP—ergo, demand is pent-up—a double-dip seems an unlikely event. Even the spent-up consumer's debt-service ratio is at its lowest level since 2000, and, owing to a generational low in mortgage rates, a refinancing boom is inuring further to the consumer's state.
Souring sentiment, reasonable valuations, an absence of inflation, the likelihood that monetary policy will remain easy and the unlikelihood of a double-dip continue to form the foundation of value-creation in equities.
In the fullness of time, there is almost an inevitability that a large reallocation trade out of bonds and into stocks is forming. If I am correct, many investors are now offside.
In summary, 10-year Treasuries yielding under 2.60% seem dear and should be shorted, while U.S. stocks trading at 12× reasonable 2011 S&P profits seem cheap and should be purchased.
Make no mistake—the road less traveled will continue to have bumps, and some of those potholes will be with us for some time:
The good news is that most of these nontraditional headwinds are now recognized by most investors, so the vehicles traversing those bumpy roads seem to be reasonably prepared and relatively well equipped.
Tactically, I would be patient, and I would not chase yesterday's strength. The journey may well prove worthwhile over the balance of the year.
Looking further ahead, the lost decade has passed us, and a new decade is upon us.
Rerisk prudently.
I find myself back to taking the (market) road less traveled once again as investors' unjustified blind faith in the success of the second round of quantitative easing (QE2) has increased the U.S. stock market's degree of risk relative to the reward.
Let me start by emphasizing that the precision of stock market forecasts in a market dominated by algorithms, momentum players and even mob psychology is an increasingly difficult exercise, but I will try nonetheless.
In early July 2010, when the S&P 500 was plummeting and closing in on the 1,000 level, I suggested that the scale had tipped to the bullish side and that equities were in the process of making the lows for the year.
Since then, buoyed by the notion that the prospects for an open-ended QE2, which would be aimed at lowering real interest rates, raising inflation rates and have a strategy that might even be targeted at the S&P 500 in order to elevate the U.S. stock market, equities have leapt forward for weeks in a routine and consistent fashion.
In light of what I expect to be a disappointing economic impact from QE2—I call it quantitative wheezing—and the negative consequences of that strategy on the majority of Americans, I now believe that equities are in the process of putting in the highs for the year.
After spending like drunken sailors during the Bush administration, Republican legislators have acknowledged that it will block even the most sensible stimulus programs, and the Democratic administration and its legislators have lost the will to fight their adversaries. As a result, the responsibility for turning around the domestic economy now lies squarely on the shoulders of the Fed.
The implementation of QE2 during the first week of November is now a virtual certainty. The general belief in its efficacy has vaulted stock markets around the world considerably higher.
The markets believe that unusual, definitive, and targeted monetary solutions will solve deep-rooted problems that, in the past, were put on the shoulders of fiscal policy.
On Wall Street, we too easily extrapolate trends. Whether it's company earnings or industry statistics or economic recoveries, policies and rescue packages, investors want to believe in the more or most favorable outcomes. So we are told by Wall Street strategists and most long-biased investors that if the liquidity infusion from the first round of quantitative easing worked in the United States, it has to work in QE2.
Throughout the market's rally over the past six weeks, I was reminded of something Milton Friedman once expressed, which I have taken the liberty of paraphrasing below to emphasize my concerns with regard to the efficacy of QE2: If you put the Federal Reserve in charge of the Sahara Desert, in five years, there would be a shortage of sand.
We have embarked on a slippery slope of policy, and, from my perch, there is too much confidence regarding a favorable outcome.
Is it really a good idea to put our investment trust in the successful policy of the Fed in its ability to fine-tune inflation and stimulate growth? After all, in the past the Fed couldn't find its way home and failed to identify the stock market bubble in the late 1990s, the housing bubble in 2003–2007 and the recent credit bubble.
In a recent interview with Fortune magazine's Carol Loomis, Warren Buffett said that he “can't imagine anybody having bonds in their portfolio.” At the same time, Fed Chairman Ben Bernanke is hellbent on buying U.S. bonds ad infinitum. Who do you have more confidence in?
I don't believe QE2 will meaningfully move the needle of domestic economic growth and will only have a limited impact on:
Conditions are far different for QE2 than QE1. Interest rates have already fallen to very low levels, and the benefits have already been felt on mortgage rates and in refinancing. Also, unlike QE1, when the world's central banks were all-in, differing policies now dominate the global landscape.
Meanwhile, our fiscal imbalances multiply, our currency craters (as a worldwide rush to currency devaluation is offsetting some of the normal trade deficit benefit), and the bulls rationalize these concerns by suggesting that the consequences “are beyond our investment time frame.”
Importantly, there are a number of other possible adverse consequences from the inefficient allocation of resources that is the outgrowth of the next tranche of monetary stimulation.
While the immediate response to the likelihood of QE2 has been to buoy asset prices, the domestic economy is stalling at around 1.5% to 2.0% GDP growth, and little improvement in the jobs market has been seen. This hesitancy makes the anemic slope of the current recovery vulnerable to the unforeseen (e.g., trade wars, policy errors, etc.) and could place the generally assumed self-sustaining economic cycle at risk. As well, the long tail of the last cycle's abusive use of credit looms large, as demonstrated by mortgage-gate.
My bottom line is that QE2 will have only a modest effect on the broad economy. Our largest corporations will fare better as interest rates drop and will profitably extend their debt maturities in a cheap and hospitable bond market, but, as commodities rise, some troubling consequences could emerge.
We are not on a road to the stagflation of the 1970s, but we may very well be on the road to screwflation.
Screwflation, similar to its first cousin stagflation, is an expression of a period of slow and uneven economic growth, but, its potential inflationary consequences have an outsized impact on a specific group. The emergence of screwflation hurts just the group that you want to protect—namely, the middle class, a segment of the population that has already spent a decade experiencing an erosion in disposable income and a painful period of lower stock and home prices. Importantly, quantitative easing is designed to lower real interest rates and, at the same time, raise inflation. A lower-interest-rate policy hurts the savings classes—both the middle class and the elderly. And inflation in the costs of food, energy and everything else consumed (without a concomitant increase in salaries) will screw the average American who doesn't benefit from QE2.
In summary, somebody holds the key to a self-sustaining domestic economy, but I doubt that it is a monetary maven, as some of the potential side effects of quantitative easing might be worse than the medicine. And the confidence and animal spirits that the markets have expressed since early September might just be blind faith.
The domestic economy remains in a contained recession, and, while containment efforts will continue with QE2, the efficacy of these efforts will likely disappoint and wane.
I continue to see the risks to 2011 corporate profit and U.S. and worldwide economic growth rates to the downside. It remains likely that secular and nontraditional headwinds will produce an extended period of inconsistent and uneven growth in the years ahead, which will be difficult for both corporate managers and investment managers to navigate. Arguably, given the sharp rise in equities, the downside risks might be growing ever greater, especially if I am correct that QE2 will be a dud.
The key to remedying today's low P/E multiples would be to apply the same amount of attention, brain power and solutions spent on short-term policy on the underlying structural problems that our country faces.
But, patience, more than policy, is something that investors, politicians and others have precious little of these days.
“In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.”
—Dallas Fed President Richard Fisher
We all recognize the intended theoretical benefits of QE2:
I am less certain than most that the theory behind QE2 will become the reality of QE2.
Below are some additional questions that should be asked in determining the ultimate efficacy and effect of QE2.
At this point, it can't be choice C given where yields already are, can it? If it's choice B, how much powder is left? If it's choice A, how do they do it? Or is there a choice I am missing?
Black swans are occurring with greater frequency.
Last week's historic earthquake in Japan contradicts the notion and appearance of stability and is yet another black swan in a series that has (time and time again) threatened the order over the past decade.
The new normal is abnormal and is bound to haunt investors for some time to come.
I am not referring to Pimco's Mohamed El-Erian's notion that world economic growth will be lower; I am referring to the new normal of disproportionate, high-impact, hard-to-predict and rare events beyond the realm of “normal expectations in business, history, science and technology” that are occurring with startling frequency.
“I'm astounded by people who want to ‘know’ the universe when it's hard enough to find your way around Chinatown.”
—Woody Allen
Risks of more and repeated black swans, previously perceived to be small by corporations, investors, politicians and regulators, should now be reassessed, owing to (among other issues) globalization, tighter correlations, advancements in technology, the growing/excessive complexities of interlocking supply chains and derivatives, the acceptance of greater/extreme risk taking, the greater connectivity of increasingly more complex systems and so forth. I see a greater and more dynamic instability as the new normal. Witness the increased regularity of economically, politically, and socially altering black swan events over the past decade (Note: three of the eight deadliest natural disasters of the past century have occurred since 2004):
We can no longer turn the clock back to a simpler time. We must play the hand we are dealt. And our time is interconnected, interlinked and increasingly complex. And our hand has, at its core, a rising number of outlier or black swan events.
We shouldn't be overly paranoid nor should potential outlier events blind us to investment opportunity. But we must be mindful.
Throughout history, there have been times when it has even been more profitable for investors to bind together in the wrong direction than to be alone in the right one. The long-term direction of equities will likely always be higher, and the crowd of optimists will invariably outperform the remnants of pessimists.
Nevertheless, for years, investors seem to have been blinded to the uncertainty of the rare black swan event. We now know that these black swans are occurring with greater regularity and with greater overall impact—and, as such, we must recognize that the occurrences may not only hold the potential for reducing aggregate growth but that the uncertainty of these outlier events could conceivably cast a pall over stock valuations.
After all, the inability to predict black swan events implies a greater inability to predict the course of economic and market history—whether it is a natural disaster, a surprising geopolitical event, or an unexpected economic or credit outcome.
It is only obvious after the fact, as investors, in particular, seem to harbor a crippling dislike for the abstract. Perhaps the problem with experts is that they do not know what they do not know.
For some time, investors have been exposing themselves to the high-impact, rare event yet sleeping like babies, unaware of it.
But recent events might bring on some nightmares.
Our domestic economy faces numerous structural issues (the most important of which are the extreme fiscal imbalances at the federal, state and local levels), with governments (here and abroad) not necessarily up to the task of dealing with the complexities.
Given the newness of these and other nontraditional and secular challenges as well as the greater frequency of black swan events, P/E multiples might be pressured and could even contract as a comparison between today's valuations to those of history can be expected to lose some of its significance and relevance.
In summary, I marvel at the confidence of strategists in a smooth and self-sustaining economic recovery in such an uncertain world.
Strategists routinely make valuation comparisons based on it rhyming with historical experience. Similar to the belief in bell curves, these comparisons should be viewed with caution, because, in all likelihood, another black swan could appear on our investment doorstep—maybe sooner than later.
In this setting, a more conservative asset mix and higher cash position than normal seems to be a prudent strategy.
Over the past 24 months, the cyclical tailwinds of fiscal and monetary stimulation have served to raise the animal spirits and investors' willingness to buy longer-dated assets such as equities and commodities (soft and hard).
The Bernanke Put (and a zero-interest-rate policy) replaced the Greenspan Put (but with a far more generous exercise price!), and market valuations have risen dramatically in the latest two-year period.
Since the market's low, as measured against trailing-12-month sales, equity capitalizations have increased as a percent of sales from 75% to 140%. And by my own calculation, stocks have risen from 13×–14× to 16×–16.5× normalized earnings. Nevertheless, bulls somewhat disingenuously argue that the doubling in stock prices is reasonable within the context of a doubling in corporate profits. But those same bulls conveniently (and selectively) dismiss the notion of normalized (not margin-inflated) earnings, while they liberally employed normalized earnings as justification for owning stocks when profits disappeared in the late-2008/early-2009 interim interval.
During the same time frame, fear has made a new low, and complacency has made a new high, as reflected a marked imbalance between bulls and bears in most investor sentiment surveys. To put it mildly and to state the obvious, market skepticism has not paid off. Indeed, the pessimists have been written off (and even ridiculed), similar to the zeal in which the optimists were written off 24 months ago.
The stimulation so necessary in keeping the world's financial and economic system from falling off the cliff has come at a cost (and with potential risks), as reflected in rising commodities and precious metals prices. The impact of policy has relieved us from the depths of the Great Decession but has arguably burdened the United States with large due bills, positioning the domestic economy with a potentially weak foundation for growth.
Consider these possible headwinds to a smooth and self-sustaining trajectory of growth:
Reflecting the doubling in share prices and relative to reasonable expectations, most (except the most ardent bulls) believe that the easy money has been made in stocks. But expectations still remain buoyed, as 1,450–1,500 S&P price targets are commonplace.
I am less sanguine, as many of the factors I have mentioned provide us with what seem to be legitimate questions regarding the smooth path of growth that has underpinned the bull market.
Near term, the stabilizers are coming off, monetary easing and fiscal stimulation are being replaced by rate-tightening and austerity—first over there (across the pond, where I witnessed protests in Paris over the past weekend) but relatively soon to our shores by our Fed and by measures of budgetary constraint instituted by our local, state, and federal governments.
The intermediate- to longer-term shift back from the prior consumption-led, finance- and housing-driven domestic economy to manufacturing-led growth presents numerous challenges to growth that the bulls have all but dismissed.
I continue to see vulnerability to full-year 2011 GDP growth projections, corporate margins and profitability.
The prospects for a smooth and self-sustaining domestic economic recovery and the attainment of $95 a share in S&P 500 profits may be in jeopardy. While this favorable outcome remains possible, it might be challenged by cyclical and secular issues and is exposed, more than most recoveries, by any number of shocks or black swans.
Changing monetary and fiscal policy will be more restrictive, and recent worldwide events have provided renewed uncertainties and unforeseen dangers that cast more questions regarding the optimistic assumptions that underscore the bullish investment and economic cases.
To this observer, consensus corporate profit forecasts have become the best case and are no longer the likely case.
Downward earnings revisions now represent the greatest near-term challenge to the U.S. stock market, as I continue to hold to the view that, at the margin, upside S&P 500 earnings and domestic economic surprises have peaked and that the probability of more earnings warnings and downward profits and economic revisions are likely on the ascent. This trend is not only a domestic observation as the near-term global growth prospects have also moderated recently due to slower-than-expected strength in other parts of the world, the aforementioned price spike, and the Tohoku earthquake.
First-quarter 2011 business activity likely ended weaker than expected, with first-quarter 2011 GDP demonstrating about a 2.5% rate of growth (far less than the near 4% consensus expectation of a few months ago). As economist and friend Vince Malanga mentioned to me over the weekend, the forward economic outlook is not inspiring and is showing signs of decelerating growth: “March ISM manufacturing index showed notable declines in the growth rates for orders, exports and order backlogs.…And core capital goods orders were surprisingly weak in both January and February.”
If businesses begin to treat the geopolitical crises and elevated oil prices as more permanent conditions, order cancellations and corporate-spending deferrals loom in the months ahead, and the 3.5% to 4.0% GDP forecasts will prove too optimistic. While job growth has recently improved, the absence of wage growth, a likely weakening in personal spending and the absence of a revival in home sales activity this spring could translate to a worse job and retail-spending picture in the months ahead (especially relative to the more optimistic consensus expectations).
I would note that not only is the near-term profit cycle at risk but, from a longer-term perspective, earnings cycles seem to be occurring with greater frequency and profits have been accompanied by more volatility and greater amplitude (peak-to-trough).
Earnings peaked in 1990. The brief recession that followed resulted in only a modest drop in profits and in share prices. The next peak in earnings didn't occur for another decade (in 2000). Both profits and stock values fell more considerably than in the early 1990s, and it took only seven years (2007) for earnings and stock valuations to rise to another higher peak. Should the pattern continue (10 years, 7 years, and now 4 years), it implies that 2011 could represent the next peak in stocks and in earnings.
There could be numerous reasons for this phenomenon. The timing of the Fed's tightening/easing actions and the role of financial innovation (and the proliferation of derivatives and growth in the securitization markets) are two possible explanations.
Nevertheless, I see nothing on the horizon that changes my expectations that the profit cycle is more mature and will demonstrate more volatility than most expect.
Just as the earnings cycle is experiencing more volatility over shorter periods of time, so are black swans and tail-risk events occurring with greater frequency. Consider that three of the eight worst natural disasters of the past century have occurred since 2004. Or that the U.S. stock market has encountered 21 drawdowns of more than 20% over the past 30 years.
Though clearly not as extreme as at its polar opposite and oversold condition at the market's generational low in March 2009, today's overbought market holds a new and different list of fundamental, geopolitical, technical, sentiment, and valuation risks.
At the very least, in these uncertain times, hedge or purchase protection.
For, if not Apocalypse now, there is a risk of Apocalypse soon.
I believe that the events over the past year highlight the likelihood that the U.S. stock market will be favored among most other investment markets in the world.
Europe's economies are moving in reverse—at best, a deepening recession is in the cards. Europe used to rule the world, but it no longer dominates. The U.S. stock market has become the best house in a bad neighborhood.
The U.S. economy is moving forward, with a 3%-plus real GDP for fourth quarter 2011 expected and growing signs that the domestic recovery will be self-sustaining (albeit, at a moderate pace).
I believe, more than ever, that the events over the past decade have highlighted the likelihood that the U.S. stock market will be favored among most other investment markets in the world.
Below are 10 reasons for my optimism:
In summary, conditions that have evolved over the near- and intermediate-term have conspired to favor risk assets in the United States over many other areas of the world.
In the period ahead, look inward (not outward), as I expect a powerful reallocation trade out of non-U.S. equities into U.S. equities.
Buy American. I am.
Bonds have achieved a near-50% total return since year-end 2009. With those outsized returns, shorting bonds has been a toxic strategy.
Over the past half-century, bonds have historically been considered a risk-free asset class.
Nevertheless, I believe bonds should now be seen as a return-free asset class that is very risky and long-dated fixed income should require a warning label for all potential buyers.
The great bull market in bonds has persisted during most of the last four decades.
Over the past 38 years (since 1974), the total return on the long bond registered negative returns in excess of 5% in only four years: 1987 (−6.3%), 1994 (−12.0%), 1999 (−14.8%) and 2009 (−25.5%).
The market landscape is littered with investors and traders who have unsuccessfully shorted U.S. bonds over the past two years.
It has been a painful experience, but often the hardest trades (and those that have been most unsuccessful) are the most profitable going forward.
So, before I outline the rationale behind the five key reasons to short bonds, given that the burden of proof lies squarely on the shoulders of the bond naysayers, I wanted to start with the five reasons not to short bonds.
Above all, the U.S. economy faces powerful secular headwinds that weigh as an albatross around the neck of a trajectory of self-sustaining growth.
In summary, the positive case for U.S. government (and corporate) debt is that there are numerous cyclical and secular factors that will weigh on domestic growth, serving as a significant hurdle against the short bond thesis.
It is my contention that even if domestic economic growth is constrained, a bond short can prosper, even under the baseline expectation of a muddle-through growth backdrop.
Bond yields are unusually low, and I would note that the current 10-year U.S. note (2.0%) is approximately one-half the yield of the recession of the early 2000s. Gold prices already suggest that the safety premium could disappear sooner than later. (I view gold as a fear trade, and the recent drop in gold prices should be seen as a forward indicator of less fear.)
While U.S. economic growth remains subpar, a reacceleration is inevitable in the fullness of time. Demand for durables (housing and auto) is pent-up not spent-up, and continued population and household formation growth will serve to unleash latent demand at some point in time.
Over the past five decades, long-dated bond yields have tracked (and averaged only slightly under) the nominal growth rate in the United States—4.4% (2% real GDP estimate plus 2.4% current inflation) compared to the yield on the 10-year U.S. note of 2.0% and the 30-year U.S. note of 3.1%—in fact, long-dated yields often exceed nominal GDP.
I readily admit that, in all likelihood, with U.S. GDP growth of less than 2% in first quarter 2012, bond prices will be relatively range-bound in the weeks ahead.
But any evidence of a resumption of growth will have a dual impact: It will likely reduce the flight to safety (reflected in bond premiums) and, at the same time, produce the historically normal and natural upward pressure on interest rates associated with an improving economy.
When this happens, bonds will, once again, become certificates of confiscation.
The housing market's shadow inventory of unsold homes is starting to clear, certain areas of the country are experiencing signs of more robust activity, and, despite low levels of new-home production (based on historical data), homebuilders are even regaining pricing power in several geographic regions.
Stated simply, the U.S. residential real estate market is about to launch a broad and sustainable multiyear recovery. And, from my perch, the share price strength in housing-related equities is telling the real story of an improving and self-sustaining home market that could continue through the balance of this decade.
As proof of my emerging optimism, I would suggest listening to Toll Brothers' last two earnings conference call presentations and the recent observations made by CEO Doug Yearley in the media.
It is my expectation that both new- and existing-home prices, which suffered price declines of close to 34% from 2007 to 2011, face a better year ahead in 2012 and over the balance of the decade.
While the housing recovery of 2012 to 2020 will likely start out slowly, owing to the large inventory of unsold homes, still-restricted mortgage credit and the current preference for renting, there is now ample evidence that residential real estate markets have already turned in a national market that has grown bifurcated. Areas of the country that are unencumbered by a large supply of foreclosed properties—for instance, the Washington, D.C.-to-Boston corridor—are doing better. Cancellation rates are down dramatically, and some pricing power is returning for the homebuilders. By contrast, areas such as inland California, Nevada, and the like continue to suffer in price and in sluggish transaction activity as a result of the indigestion of the last cycle.
In other words, the weaker regions are masking a developing national recovery in housing that has the potential to be more durable and healthier than the past cycle.
Below are the seven main reasons why (in conjunction with the Toll Brothers comments) I expect a durable recovery (in demand, activity/transactions and in prices) in the U.S. housing market:
Pride goeth before a fall—also publicity, handshakes and celebrity. The biblical injunction about the first and the last trading places often has literal truth. Thus, stocks and bonds, which fared poorly in the inflationary 1970s, excelled in the disinflationary 1980s. The country's most admired companies (as listed annually in the glossy business magazines) are frequently on their way to becoming among the country's least admired investments. When a cynical investor hears that there are too many optimists in the market, he will begin to worry. By the same token, an over-abundance of pessimists will give him courage. After all, he may ask, if everyone is already bearish, who is left to sell?
—James Grant, Minding Mister Market: Ten Years on Wall Street With Grant's Interest Rate Observer
Apple has been a once-in-a-century profit dynamo that has prospered and has expanded its market share by delivering innovative products and expanding its self-sustaining ecosystem.
The chart of Apple's shares since 1985 is remarkable.
In the 1960s and 1970s, the stock market was inhabited by the “Nifty Fifty,” a small subset of one-decision stocks that had strong balance sheets, solid franchises (typically leaders in their field), relatively superior profit prospects and were generally credited with the bull market of that era. Some examples of the Nifty Fifty included Wal-Mart, Avon Products, Disney, McDonald's, Polaroid, and Xerox. The stocks flourished for a while but ultimately became overvalued and were weighed down by the bear market that continued until 1982.
Today there is no more Nifty Fifty, arguably there is the nifty one—and that one is Apple. The Wall Street analytical community and many money managers are unambiguously and unanimously optimistic about the company, but let's not lose sight of the fact that the sword is double-edged, as an investor who bought the Nifty Fifty at the end of 1972 would have had 50% less wealth by year-end 2001 relative to an investor who bought the S&P 500. (Sic transit gloria.)
Over the weekend, the New York Times's Joe Nocera wrote an interesting article that speculated that Apple has peaked.
It got me thinking, and below I highlight a list of 10 concerns, fully recognizing the current quarter will be ahead of expectations.
Apple's significant role in the indices and its extraordinary relative and absolute performances have been an important determinant of investment returns. A portfolio heavily weighted to Apple has been a ticket to outperformance. By contrast, a portfolio dismissive of Apple's prospects and underweighted the stock has underperformed.
But the preceding paragraph modifies the past; it does not necessarily hold for the future.
Investment history shows that when there is such unanimity of good will bestowed toward a corporation's equity, when the very share price performance of only one security has such a profound impact on aggregate investment returns, when a record amount of analysts (53) follow an individual company with enthusiasm and optimism and when a company's total capitalization is mentioned in the media constantly and throughout the trading day, resonating throughout the investment community, it is time to be on guard if not concerned.
Surprise No. 10: Despite the advance in the U.S. stock market, high-beta stocks underperform. Though counterintuitive within the framework of a new bull-market leg, the market's lowfliers (low multiple, slower growth) become market highfliers, as their P/E ratios expand. With the exception of Apple, the highfliers—Priceline, Baidu, Google, Amazon and the like—disappoint. Apple's share price rises above $550, however, based on continued above-consensus volume growth in the iPhone and iPad. Profit forecasts for 2012 rise to $45 a share (up 60%). In the second quarter, Apple pays a $20-a-share special cash dividend, introduces a regular $1.25-a-share quarterly dividend and splits its shares 10-1. Apple becomes the AT&T of a previous investing generation, a stock now owned by this generation's widows and orphans.
—Doug Kass, “15 Surprises for 2012” (December 27, 2011)
I have written positively about Apple this year.
While I recognize that valuation and concept shorts are usually a free pass to the poor house, Joe Nocera's editorial to me was a reminder that, as Grandma Koufax used to tell me, “trees don't grow to the sky.”
There is no better time to consider the negative case for Apple given its marked outperformance and its recent penetration of the $700-a-share mark.
The upcoming quarter will be big for Apple. The fastest ever rollout for iPhone 5 will be accompanied by higher-than-expected margins, as there are two separate cost-reduced models now. Soon everyone will know that, and if not fully in analyst numbers, it will be in buy-side expectations. (See the recent rise in the stock even after what was viewed as a somewhat me-too product launch.)
Today, there is an almost unanimous view that the strength in housing will be the most important factor (or one of the more important factors) in offsetting the fiscal drag associated with the spending cuts and tax-rate increases (necessary to pare down the burgeoning U.S. budget).
To many, a booming housing market seems to be an almost single justification for ambitious economic growth targets and for an enthusiastic view of the U.S. stock market.
Optimism surrounding the housing market wasn't the case 18 months ago—indeed, back then there was a great deal of skepticism (that I didn't share).
Over the past year and a half I have consistently made the case that the housing market's upside would surprise most investors over the near term and that the U.S. residential market is likely to embark upon a durable and multiyear recovery.
The key points I made in my prior analysis were that the benefits of historically low mortgage rates, vastly improved home affordability and pent-up demand (once the U.S. economy and jobs market stabilized) would yield higher home prices and rising sales turnover. Some of these factors remain in force, but other depressing factors have been introduced that could produce a halting consumer, uneven housing activity and less certain home pricing over the course of 2013.
While I remain of the view that a durable housing recovery is in place, I am less optimistic about the next 12 to 15 months.
The housing recovery may not be steady in progress, smooth in growth and uninterrupted in its trajectory.
The fact is that housing as a series (in activity and prices), more often than not, exhibits volatility—even when it's on the way toward recovery.
In early 2013, the U.S. consumer faces uncommon hurdles that could adversely impact the housing markets and lead to disappointing personal consumption trends.
Specifically, given the backdrop of higher individual tax rates, reduced government spending, a possible trend toward higher interest rates and a still-chastened single-family homebuyer (who has recently faced an unprecedented 30% drop in home prices), I do not anticipate a smooth recovery in housing over the next 12 to 18 months in the face of these macro and consumer headwinds.
The single-family housing market lacks durable leadership—repeat buyers are carrying the housing market. The more important first-time homebuyers are out of firepower and peaked in May 2012, investor buyers peaked in June 2012, and all-cash existing sales volume turned flat in December 2012.
I worry that the Fed's stimulus, which induced a housing recovery over the past 18 months, might have even pushed forward home activity and demand and could conceivably produce a 2013 hangover.
Even if housing continues to recover and exhibits something more than a stimulus-related bounce, it would take a hell of a rise in construction activity to impact aggregate U.S. economic growth given construction's relatively small role in GDP. For illustrative purposes, let's presume the consensus is correct and that the residential housing market will continue to exhibit strong growth. Construction represents only about 3% of GDP. Therefore a 20% increase in construction activity will only positively impact GDP by 0.6% (before the multiplier effect takes hold). This compares against a likely 1% to 2% headwind from spending cuts and higher taxes. (I am using a larger multiplier than most.)
Bottom line: The future outlook (in both home sales activity and for home prices) is principally a function of three variables (and I hold to a less-than-optimistic view of all these factors).
These three categories are not setting up to provide steady growth in the U.S. housing market over the near term—there are numerous question marks.
My baseline expectation is for (at best) 1.5% real GDP growth in 2013—this is below consensus expectations. And I believe there is further risk to the downside.
I remain particularly cautious on the consumer (and homebuyer), who, despite a slightly improving jobs market, faces numerous headwinds.
Over the past week the yield on the 10-year U.S. note rose from 1.82% to 1.95%. The consensus appears to be that the 10-year will rise no higher in yield than 2.25% to 2.50% in 2013—based in part on continued deleveraging, slow growth and a friendly Fed (which will effectively repress long rates). Homebuyers have become accustomed to low mortgage rates, but I would caution that given housing's historic rate sensitivity, any rise in interest rates above consensus expectations could immediately provide a headwind to the U.S. housing market. Indeed, I expect refinancing and purchase applications to suffer in the near term if rates continue last week's rise.
The average middle-class U.S. consumer is beaten up.
Faced with two large stock market drawdowns in the last decade, a flash crash, screwflation (in which income has not kept pace with the costs of necessities of life: insurance, education, food, etc.), the largest economic recession since the Great Depression, continued jobs insecurity and a 30% drop in home prices, consumer behavior has changed and is not likely to revert to the historical spending patterns exhibited in the last few cycles.
A very good example of this is the evidence that individuals failed to purchase domestic equities until January 2013, as buying stocks took a backseat to making ends meet. As it relates to housing, the stunning drop in home prices in 2007–2010 will probably continue to be associated with a more conservative view toward home ownership and with a greater desire to rent. This helps to explain the continued lackluster single-family home market.
We can see this phenomenon demonstrated in the continuing dominance of multifamily starts relative to single-family starts throughout 2012. It will be interesting to see how the enormous supply of apartments will impact rents and home prices in the coming year.
In summary, while a real estate recovery is under way, a full-blown housing recovery is probably a few years away.
I can see several factors (fiscal drag and higher interest rates) negatively impacting the consumer and serving to cause unevenness or even a pothole in the current housing recovery.
The housing market will not save the U.S. economy, and growing optimistic expectations for the residential real estate market are not likely to be met in 2013–2014.
Even if I am understating the recovery in housing, construction activity represents a relatively small fraction (3%) of GDP, and, as such, its aggregate impact on domestic economic growth is probably being overstated by many.
Since early May, the yields on 10-year U.S. Treasury notes and 30-year U.S. bonds have risen abruptly, by a bit more than 50 basis points. Yesterday was the worst day for U.S. fixed income in years, with a 6.5% increase in yields (10-year). Stated simply, the markets are running ahead of the Fed's tapering.
The bullish argument on interest rates is that as long as rates don't rise too fast, the optimistic outlook for the economy and the equity market will remain intact. I am less certain, as I see a false economic dawn in the United States and around the world.
The bottom line is that interest rates are an important raw material of the U.S. economy. As they rise, it will affect everything (profits, capital spending, hirings, etc.), and stock prices will likely have to adjust (and the adjustment won't be upward).
U.S. corporations, consumers and even our government are addicted to lower interest rates.
What about the widely anticipated great rotation out of bonds and into stocks?
We haven't seen it yet, and I suspect we won't. Even if interest rates rise, given the still-uncertain fate of the consumer (screwflation, the aftermath of the Great Decession, the second large stock market drawdown in a decade, the still-elevated unemployment rate as corporations rerate their full-time job needs in the face of the costly burden of Obamacare), my guess is that the yield-deprived consumer/retiree will grab higher-yielding fixed-income instruments that they perceive to be safer than stocks.
What impact will higher interest (and mortgage) rates have on the all-important U.S. real estate markets?
In my view, plenty.
Already, a small rise in rates has adversely impacted mortgage purchase applications. After falling by 9.8% two weeks ago, applications dipped by another 8.8% in the past week. This is especially true if not only mortgage rates climb but if home prices continue to firm; this is a toxic cocktail that is already showing signs of pricing first-time buyers out of the market.
Making matters worse and housing markets tighter are (on the supply side) recent regulations' impact on a slower pace of foreclosure sales as well as (on the demand side) the aggressive push by hedge funds and other institutional buyers to purchase homes (to rent out).
“What hath Kuroda wrought? JGB yields a bigger influence on Treasuries than tapering potential.”
—Pimco's Bill Gross
Then there is Japan and its bond market where the recent rise in Japanese government bond (JGB) yields could threaten Japan's recovery (as the country's debt-to-GDP ratio is 200%) and, arguably, is beginning to impact U.S. bond rates. Indeed, one can argue that the price movement in JGBs is having more of an impact on our fixed-income market than the prospects and perceived timing of Fed policy (and tapering).
Finally, every discounted dividend model utilizes interest rates in calculating fair value. Higher interest rates reduce the theoretical value of the market and individual stocks.
As well, higher Treasury yields will not only continue to hurt the rate-sensitive segments of the U.S. stock market (utilities, staples, etc.), but they will also likely result in fixed-income products becoming more appealing to yield hounds.
A 50-basis-point rise in U.S. note and bond yields in just three weeks is being ignored by the market participants. This might be a mistake in judgment as the seeds of slowing economic growth accompany the planting of higher interest rates.
The bottom line is that as interest rates rise, it will affect everything; prices will have to adjust, and the adjustment won't be upward.
Beware of the interest rate cliff—the addiction to low interest rates runs deep.
The sharp two-month climb in interest rates represents a significant credit event.
The rate rise will have reverberations for housing, on the general economy and for the U.S. stock market.
I remain of the view that many areas in both public and private sectors are far more vulnerable to the recent rise in interest rates than most market participants recognize.
Among the areas most impacted by a ratcheting in interest rates is housing.
Back in early 2012, I adopted a variant view and suggested that housing's recovery would surprise most to the upside. And while housing's momentum has been impressive over the past year and the sector appears to have entered a long-lived recovery, I now suspect that a surprising pause (of consequence) could occur over the next six to 12 months.
I would now avoid most housing-related stocks.
A possible slowdown in the U.S. housing market will have broad economic implications, and some second-half domestic economic forecasts might prove to be too optimistic. I expect no better than 3% nominal GDP growth (1.5% real) over the last two quarters of this year. Importantly, this well-below-consensus projection is a big departure from the Fed's official forecast of over 4% nominal GDP, which provides a guideline to monetary policy.
My more sobering economic view incorporates the recent improvement in the jobs market but recognizes the continued weakness in business capital spending and the drag from lower government expenditures combined with the anticipation of moderating retail sales and personal consumption (given a five-year low in the savings rate and the anticipated loss of refinancing-aided household cash flow).
Let's consider the ramifications of the sharp climb in interest rates since early May on the U.S. housing market. A slowdown in the residential real estate markets will pose a threat to existing- and new-home sales, home prices, builders and bank earnings and the home improvement market.
It is important to recognize that only a handful of inflated sales prices can buoy a community of homes. We can already see the pressure in a marked reduction in the participation in first-time buyers (to under 30% of national sales from 40% a year ago). Real estate maven Mark Hanson has estimated that first-time buyers' volume is down 60% to 70% in the last two and a half years.
Almost as significant as higher home prices is the accelerated rise in conventional mortgage rates—almost unprecedented in terms of percentage off the lows but still low by historical standards.
But it is important to recognize that the absence of exotic loans available in this cycle compared to the previous cycle means that purchasing power has been markedly lowered. (The traditional housing affordability indices don't properly take this into account.)
It takes nearly $100,000 of income in 2013 to purchase a $523,000 home compared to only $66,000 needed in the 2000s.
Year-to-date, these two factors have reduced the purchasing power of buyers by more than 20%. Organic buyers' ability to move up has also been diminished, as it will grow more difficult to sell the first house and/or buy the new home.
The sharp climb in interest rates since early May points to some prospective weakness in the U.S. housing market (measured both by sales activity and prices) and is conspiring to reduce overall domestic economic growth to levels likely unforeseen by policymakers and by most forecasters.
The drag of fiscal austerity, tax and regulatory policy will also weigh on U.S. growth. Non-U.S. growth remains subpar. Inflation will continue to be more of a threat than deflation.
Though the global financial condition is greatly improved from four years ago and the ECB, Bank of England and Bank of Japan are on the same ZIRP page, in this slow-growth backdrop, policy risk (of premature tapering) is heightened and represents an ever-present threat to the U.S. stock market.
Housing, in particular, seems exposed to the quick climb in rates. It remains my view that prospective homebuyers—still shaken from an unprecedented 34% drop in home prices from the peak and in the face of stagnating wages and salaries—are far more sensitized to costs (home prices and mortgage rates) than many believe. The fence-sitter argument (i.e., that buyers will appear as rates rise) seems to have been debunked by the recent decline in purchase applications. And given the lack of opportunities available today in the creative, no-/low-documentation mortgages of yesteryear, affordability trends in 2013, though still attractive measured by history, are becoming a stronger headwind to housing.
I would avoid housing-related equities and mortgage-centric banks in the months ahead, and I would be skeptical of the consensus forecast of a meaningful acceleration in domestic economic growth (from second-quarter 2013 estimates for real GDP of less than 2% to nearly 3% in the second half of 2013).
As to tying this all into the overall stock market's outlook, an abrupt rise in interest rates as we have just witnessed—Friday's rate rise was the largest one-day increase in nearly five years—need not necessarily spell doom if profits are on a strong trajectory.
Unfortunately, this is not the case, as an unsettled and volatile fixed-income market is being accompanied by a less-than-stellar profit backdrop. Second-quarter 2013 earnings (excluding financials) are forecast to drop by about 1% while top-line sales increase by only 1.5%.
Second-half earnings are being projected at nearly 10% growth.
Similar to the ambitious housing projections for 2013–2014, the U.S. corporate profit outlook seems too optimistic as well.
The massive rally in the U.S. stock market has increasingly ignored that quantitative easing has become an ineffective stimulant to domestic economic growth.
Second-quarter 2013 real GDP now looks to be under 1%, well below expectations when the quarter started. This follows only 0.4% in fourth quarter 2012 and 1.8% in first quarter 2013—both of which were well under forecasts as well. In nominal terms, the GDP growth rate will likely drop from 3% in first quarter 2013 to 2% in second quarter 2013.
As a result of weak nominal GDP, sales growth in both the first and second quarter of this year has been nonexistent.
Second-half growth expectations for the domestic economy (as well as the forecast by the Fed) remain in the area of 2%. Recent economic data suggest that these projections may also fall short.
Optimistic second-half forecasts incorporate the view that fiscal drag is receding, job growth is improving, the wealth effect should take hold (and trickle down) and that the U.S. housing market will continue to strengthen. I am less certain that fiscal drag will moderate and that the housing recovery will continue to be strong.
Moreover, a favorable analysis of the jobs market fails to take into account the rising percentage of part-time (and low-paying) jobs and a generally anemic wage growth outlook. As well, the trickle-down theory fails to recognize that this effect is far less important than the income effect on overall spending. With the personal savings rate at a five-year low, it is unlikely that personal consumption expenditures will be strong enough to generate inventory rebuilding at the corporate level and, thus, a virtuous or self-sustaining economic cycle.
Of course, second-half projections also have to incorporate the non-U.S. picture. Unfortunately, the global economy still lacks an engine for meaningful recovery. China may no longer be the engine of growth that it has been in the past, and the eurozone's economy remains strained.
Finally, there is the issue of interest rates and our addiction to their low levels. Tapering appears around the corner, and we shall see if the equity market will be tolerant or if rising interest rates act as a headwind to growth and the expected rebound in second-half growth fails to materialize.
While second-half 2013 S&P 500 earnings have exceeded expectations (with year-over-year growth of close to 5%), much of that improvement has been confined to the financial sector, where share buybacks, and reserve reversals have buoyed results.
Importantly, if we exclude financials (which benefited from buybacks and lower loan-loss provisions or reserve releases) from overall results, both first- and second-quarter earnings growth are barely expanding and are likely to be flat to down.
In other words, the quality of earnings growth and the absolute rate of growth in profits (excluding financials) thus far in 2013 have been poor.
Rather than take down valuations reflecting this poor earnings quality, the weak absolute level of nonfinancial earnings and tepid sales growth, to my surprise, market participants have elevated valuations.
In fact, the year-over-year change in the S&P 500's P/E multiple has been roughly 4.2× the average year-over-year increase in the last 35 years.
I now believe that 2013 S&P profits will total about $107 a share and 2014 S&P profits will fall in the range of $109 to $110 a share. These estimates, though slightly higher than I expected when the year began, are about $1 to $2 below 2013 consensus projections and $5 to $6 below 2014 consensus projections.
The previously mentioned domestic economic growth dynamic calls into question whether the United States is in a self-sustaining recovery or whether our economy is still, four years after the end of the recession, dependent upon continued and unprecedented easing in monetary policy and the maintenance of zero interest rates.
Based on the dialogue over the past two months, it is clear that both the Fed and other central banks are fearful of spooking the markets. Nevertheless, it is also clear that global bond rates have likely completed a three-decade decline.
Given these conditions, it is increasingly clear that the benefits of quantitative easing have been diminished with each round.
The cornerstone of the bull market case is that valuations are reasonable and not excessive by historical standards. It is further argued by the bulls that given the low rate of inflation (and inflationary expectations) and very low interest rates, the current level of valuation is justified and even inexpensive.
The conventional method of calculating P/E multiples based on stated or raw earnings is, arguably, a fundamentally flawed approach that assumes currently elevated profit margins and profits are sustainable. Indeed, measures that normalize margins have almost always correlated better to U.S. stock market performance over history.
It is only the cyclical (and elevated) position of profit margins that prevents recognition that equities are richly valued.
I would argue that to utilize earnings that reflect profit margins that are more than 70% above the norm (over a documented span of over 65 years) is an aggressive assumption and fails to adjust for the unique and changing conditions that contributed to the sharp improvement in margins since 2009—all of which are deteriorating and likely putting renewed pressure on margins.
Investors should consider evaluating current valuations from the context of normalized earnings not based on today's elevated (raw) profits and profit margins.
There are three important factors that have contributed to unusually high corporate profit margins—all of which have begun to reverse.
Over history, profit margins are among the most mean-reverting economic series extant.
Raw P/E and raw price-to-forward-operating-earnings look reasonable only because profit margins are about 70% above their long-term norms.
Every ounce of my cynicism and analysis is supported by historical precedent.
With the assistance of Dr. John Hussman, the elements of my overvaluation case are underscored by the following seven items that look beyond raw earnings:
My argument might be rendered moot if global economic growth would begin to accelerate meaningfully—in that case, corporations would achieve operating leverage—or if interest rates would stay abnormally low.
These are not my core expectations.
The profit landscape remains challenged, and interest rates, in the fullness of time, will be rising.
For 2013, I expect a below-consensus forecast of between $107 and $109 a share for S&P profits (the consensus is for full-year profits of $109 a share). For 2014, the consensus estimates that the S&P 500 will achieve profits of about $116 to $120; my base case estimate is for $112 to $114, a gain of under 5% (year over year), which is, again, below consensus.
Slowing sales, a contraction in margins, the reduced influence/benefit from aggressive monetary policy and political uncertainties are some of the reasons why my baseline earnings expectations are for below-consensus 2014 S&P profits.
The strength in stocks throughout most of 2013 has been consistent and spectacular, and arguments such as what I have expressed have fallen on deaf ears.
The reality is that shorts have been a hedge against profits.
That said, most people get interested in stocks when everyone else is, but the time to get interested is when no one else is.
This is certainly not the case today, as investor sentiment and higher stock prices have turned almost universally optimistic these days.
But a public opinion poll is no substitute for thought.
Near the end of enormous upside moves such as we have experienced since the generational bottom in March 2009, analysis often goes unquestioned as new-era thinking is embraced.
We all know how badly the dot-com/technology era ended a few years after the misguided view of a long boom.
My argument today is that using raw earnings to justify current valuations might be misplaced logic, as, from my perch, the irrational is being rationalized.
At the least, the reward vs. risk remains unattractive in the U.S. stock market.
At the worst, a Minsky moment may lie ahead in the not too distant future in which asset values drop following a lengthy period of prosperity and increasing value of investments.
Investors of all sizes and shapes are nearly all in the pool now.
Investor sentiment (in most surveys) is tilted very bullish, mutual fund investors hold near-record-low cash reserves, hedge funds are at multiyear highs in terms of net long exposure, and retail investors (though not at the extremes of 1999–2000) have plowed money into domestic equity funds en masse since the beginning of the year.
Importantly, margin debt reached another high in October of $413 billion (up 3% month over month after rising 5% in September). In fact, margin debt is approaching the March 2000 and July 2007 highs as a percentage of GDP. Currently, margin debt is about 2.4% of nominal GDP vs. 2.6% in July 2007 and 2.8% in March 2000.
The many potential headwinds (e.g., Washington shutdowns, geopolitical risks/uprisings, a probable taper, rising interest rates, tepid corporate sales and profit growth, signs of ineffective Fed quantitative easing policy, the vulnerability of corporate profit margins, the growing schism between the haves and the have-nots in a failure of trickle-down economic policy, the consequences of financial repression done for the greater good on the savers class, etc.) have, to date, been ignored and dismissed by stock market participants.
Importantly, the disconnect between the real economy and the stock market has grown more pronounced, as the markets continued their ascent in recent months.
The most recent leg of the bull market started at about 1,670 on the S&P 500. Since then, the S&P has rallied by over 8%.
The joyous swimmers have returned to the investment pool in numbers during the munificent climb from the market depths of 2008–2009.
Not only have traders and investors ignored the potential investment headwinds, but they have rewarded the S&P 500 with a quantum increase in valuation. Though P/E ratios have risen on average only 2% a year since 1990, valuations have climbed by nearly 25% in 2013.
There has been a lot of bubble talk of late. That talk (and the very existence of those questioning bubbles) seems to many as a rejection that there is a stock market bubble at all.
The problem with bubbles is that if you sell stocks before the bubble bursts, you look foolish, but you also look foolish if you sell stocks after the bubble bursts.
The market is not yet a bubble; it is simply overvalued (maybe by as much as 10%).
If I were pressed, however, to express if and where the bubbles reside today, they likely exist in the extraordinary faith in the Fed and central bankers around the world to shoulder the responsibility of catalyzing economic growth and in the general notion that corporate profit margins (and thus the outlook for future corporate profits) are inflated and in bubble territory at about 80% above the long-term average over the past six decades.
To date, the aforementioned headwinds have been seen simply as opportunities for investors to buy more stocks on weakness.
Grandma Koufax used to say, “Dougie, investment trees don't grow to the skies.”
To a rising chorus of self-confident and almost boisterous bulls, fueled by a nearly unprecedented and continuing market rally, the investment trees indeed appear to be rising into the sky.
The argument, gaining credence with every 10-handle move in the S&P 500, is that with short-term interest rates anchored at zero, there is no alternative. But as Tennessee Williams wrote, “There is a time for departure even when there's no certain place to go.” For, at many points in history, regardless of yield, cash has been king.
One day, perhaps in the near future, our investment pool will be drained.
When that will happen (tomorrow, in two weeks, in two months or in two years) is anyone's guess.
While the catalyst to the first meaningful market correction (in some time) can never be known for sure, it could come in the form of poor forward profit guidance, recognition that profit margins will mean revert or, more likely, it might just be that buyers have been sated when they all are in the same pool.
In less than five years, we have moved from a generational market low to a generational market high, and investors (many of which started 2013 in a sour mood) are now anticipating a sequel in the year ahead.
Stock market history teaches us to be mindful and respectful of patterns but also to recognize the influence and importance of the unexpected.
Today, investors, strategists, and the business media seem to have a singular focus.
They are currently obsessed with forecasting when a taper will be introduced and are attempting to interpret its impact on the bond and stock markets.
When it is universally agreed that one factor (tapering) holds the key to the market, it likely means that that determinant is priced in (and so, I might add, is the likelihood of very dovish forward guidance coincident with the inevitable tapering).
According to a Bloomberg survey of economists, there is a 34% probability of a December tapering, a 26% probability of January and a 40% probability in March.
My view is that a December tapering has almost a zero probability, as there will be insufficient economic data to make the decision and it could potentially disrupt year-end funding and confidence (during the important holiday sales season). A more likely January tapering would encompass three full improving jobs reports, incorporate holiday sales results and there would be greater visibility of the outcome of fiscal debate in Washington.
As to interest rates (the second part of the riddle), that's a more interesting question.
Specifically, what level of interest rates would pose a risk to stocks (defined as a 5%-plus correction)?
Most view 3.25% or higher in the 10-year note yield within three months (indicating that yields have broken out of a two-and-a-half-year range and that forward guidance is not sufficient to hold down rates), 3.75% or higher within six months, 4.25% or higher within nine months or 4.5% or higher within 12 months as threshold points. My view remains that 3.5% or higher will be surprisingly negative for housing, the mortgage-backed securities market and potentially for the stock market.
Thus far, the capital markets have not been impacted by somewhat improving economic data.
In all likelihood, what will really move the markets over the next six to nine months isn't priced in at all right now. As mentioned previously, the consensus on tapering (it's schedule and market impact/importance) is more or less all the same—that is, January or March in timing (67% chance) and basically not impactful and essentially irrelevant to the markets.
This is likely the natural outgrowth of a forgiving market with a strong degree of momentum to the upside that has ignored any potential headwind (economic, interest rate, geopolitical, political) throughout 2014.
Nevertheless, at this point in time, it remains probable that the market's consensus will prove wrong on its almost singular focus on tapering—in the same way the crowd has been wrong in assessing the outlook for interest rates, the stock market and for asset classes over the past 12 months.
The rush to risk over the past 12 months and the performance of numerous asset classes have been noticeably at odds with consensus expectations and different than what nearly anyone expected a year ago. At year-end 2012: The markets were closer to being oversold; they are now severely overbought.
The outflow out of stock funds was at the highest level since the 2009 generational low. Throughout 2013, we have seen steady inflows into equity funds.
Wall Street strategists were well grouped to expect a modest rise in stocks (of 5% to 10%). Stock returns were 4× that this year. They were, as it is written, cautiously optimistic. Today strategists, though still relatively muted in forecast, have begun the one-upmanship of who has the highest S&P 500 price forecast. At the very least, the bearish are being ridiculed, causing massive changes in expectations from strategists and, to be sure, the late exit/capitulation of nonbelievers and short-sellers.
Investor sentiment, cautious a year ago, has been replaced with sentiment being as positive as at any time in the five-year advance (based on the various sentiment surveys). Indeed, at a ratio of 4:1, the bull-to-bear ratio is at the highest level in nearly 25 years.
Technicals were unimpressive/uneven throughout the last half of 2012. Transports were in a downtrend that started in mid-2011, there were numerous breadth divergences that began in second-quarter 2012, and utilities were recovering nicely from a late-summer fade. Today, the technicals, a reflection of strong price momentum, are universally seen as the world's fair and supportive of continued market gains.
The 10-year U.S. note was yielding about 1.60% vs. nearly 2.90% today. Inflows into bond funds in December 2012 were at near-record levels. Today those funds are being disintermediated in accelerating fashion.
Emerging markets were at 18-month highs. In 2013, emerging markets have been conspicuous underperformers. The price of gold was near an all-time high (at $1,750 an ounce). The price of gold has crashed this year.
Most important, there was little attention paid to the Fed's intention to continue QE/ZIRP ad infinitum. Today we are unduly attentive to Fed monetary policy and interest rates (nearly held hostage), which seem to weigh in all our decisions and in the market narrative.
A surprising influence (other than tapering or interest rates) will likely impact the markets in the year ahead.
I don't have a crystal ball, but it could take many forms.
On the negative side, it could be an unforeseen black swan event that no one is now considering or growing evidence that corporate profit margins are vulnerable to a regression toward the mean or it could just be that the market sells off because the demand has been sated.
On the positive side is that the forgiving nature of the market could lead to an upside blow-off sometime in 2014. Though sounding like a two-handed observer, I, not surprisingly, would say that reward vs. risk justifies a more cautious stand.
The great investors survive on that which is unpredictable—the unexpected courses through their investing veins.
In conclusion, I would search for factors other than tapering that will shed light on the performance of equities next year.
Expect the unexpected.
It has been nearly five years since the Great Decession and the ensuing generational bottom in the U.S. stock market.
The S&P 500 has risen from 666 to almost 1,850. At 58 months, the current cyclical bull market advance is the second longest on record and is quickly approaching the 60-month expansion that occurred from 1982 to 1987.
Nevertheless, aggressive monetary stimulation has arguably (ex-inventory accumulation) failed to ignite escape velocity for the domestic economy, and the U.S. is yet (in my view) in a position to forge a self-sustaining recovery.
The single most important reagent to higher stock prices last year has not been better corporate profits—rather it has been an upward adjustment in P/E ratios.
In 2013, P/E ratios on the S&P 500 rose by 25% vs. the average annual increase in P/E ratios since 1990 of only 2% per year.
Twelve months ago, there were virtually no Wall Street strategists that anticipated such an acute upward adjustment in valuations. Today, there are virtually no Wall Street strategists that are skeptical of current valuations.
In fact, bullish investor sentiment has been elevated to levels rarely seen. The lowly VIX is a sign of complacency, a wall that the market has climbed over the past 18 months. The market bears are ridiculed by the business media, and the short community is a species that is on the verge of extinction.
I would argue, therefore, that the market has climbed a wall of complacency.
A growing consensus is finding it difficult to conceive of any negatives or headwinds to more gains in the global markets in 2014. “The only thing people are worried about is that no one is worried about anything.…That isn't a real worry,” wrote Morgan Stanley Chief U.S. Equity Strategist Adam Parker recently.
I have learned over my stock market career that investors would far prefer to buy on price strength than on price weakness—and that the crowd of investors typically outperforms the remnants, as trends generally stay in place for extended periods of time.
In its later stages, however, a sustained market advance inevitably brings (or sucks in) money managers, Wall Street strategists (who face career risk in missing out) and investors (who are overcome by similar emotions).
Maturing bull markets grow forgiving, and the rigor of analysis gets diluted by the joy (and ownership) of the advancing shares of market leadership. In time the lens of the microscope that inspects the quality of earnings (growth) as well as the one that gauges the future outlook breaks and is tucked away in a closet underneath reams of critical analysis.
The strength in global stocks over the past few years has been resounding in force and duration. Earnings, however, “the mother's milk of equities” (hat tip Sir Larry Kudlow), buoyed by share buybacks and the paring back of fixed costs, have been lackluster, as top-line sales growth continues to be punk. And forward guidance has been disappointing, with the ratio of lower guidance to higher guidance at near-record levels.
For those looking unsuccessfully for reasons to be cautious, we need only to look at the loss of momentum in corporate profit growth as we enter the new year.
It is still early in the earnings season, and at the risk of negative data mining, thus far there have been a number of high-profile misses, including Citigroup, Wells Fargo, CSX Corporation, Royal Dutch Shell, Intel, Fastenal, Best Buy and many other retailers, Capital One, Ford, General Motors, United Parcel Service, Elizabeth Arden, and so forth.
The reduction in fixed costs is more or less behind corporate America. Interest rates have seen generational lows and, in the fullness of time (2015/2016?), will be rising along with interest costs. The lower effective corporate tax rates will also likely be a thing of the past, as one day, our fiscal issues will have to be addressed by responsible policy and with the implementation of higher taxes to generate more revenue to the government. Profit margins are also vulnerable to a rising U.S. dollar, as a large percentage of S&P profits are the outgrowth of overseas sales.
Profit margins (one of the most mean-reverting economic series extant), at over 70% above multidecade averages, are exposed. Utilizing raw, stated, and nominal earnings (and inflated margins) in looking at where valuations might reside in an historical sense (in other words, not normalized profits and margins) could prove to be a fool's errand.
Individual investors and portfolio managers (who are paid to worry) should always be concerned whether lying within consensus or outside of consensus.
As we begin 2014, there rarely has been such a consensus with regard to the direction of the major investment asset classes—namely, stocks up and bonds down.
As well as equities delivering roughly a 10% return and bond yields rising modestly, there is a strong consensus about nearly everything else. The following views have been overwhelmingly embraced by the majority:
I believe that there is a lot of room for disappointment to the consensus, and I have adopted the opposite view regarding some of the above items.
Specifically, I expect bonds to outperform stocks in 2014 as the rate of growth in domestic (under 2%) and global GDP growth (under 3%) decelerates as the year progresses.
Against the backdrop of a high-single-digit decline in the U.S. stock market, the return on long-dated, taxable U.S. bonds could be between 5% and 10% in 2014.
I also anticipate that interest rates will decline from 2013's year-end levels and that the yield on the 10-year U.S. note will spend most of the year between 2.5% and 3.0%.
Many argue that Mr. Market is climbing a wall of worry. I contend that Mr. Market is climbing a wall of complacency.
There are numerous reasons for my downbeat market view this year—one of my greatest concerns is that massive central bank liquidity has obscured price discovery. Each tranche of quantitative easing has resulted in a reduced effectiveness in fostering growth. Even Federal Reserve Bank of New York President Bill Dudley has recently stated that he has no idea what QE has accomplished. One has to wonder what will happen to the stock market in the process of bond purchases moving from $85 billion a month to zero.
Below are a few additional concerns (in no order of importance):
I recognize fully that the market's phenomenal advance is what it is.
It is often said that price is truth—it is all that matters.
Market trends stay in motion until they are disrupted, but (honestly) neither I nor anyone else knows when a stock market correction might occur, or, for that matter, what the catalyst will be.
Tops tend to be more elusive than bottoms. Tops are more of a process while bottoms are typically quicker and more obvious.
Rather than predict a top, I often find it helpful to establish upside/downside objectives in individual stocks and in markets in order to ascertain reward/risk and appropriate market exposure.
To me, the S&P 500 has no more than a 5% upside and has about a 12.5% downside over the balance of this year.
In other words, the downside to the U.S. stock market exceeds the upside by a factor of 2.5×.
In conclusion, we shouldn't lose sight of the big picture, which suggests, to this observer, that there is much more downside than upside in the markets and that risk, increasingly alien to many investors inured to the market's rewards since 2009, will likely happen fast and when few expect it.
Over the past few weeks, many money managers and strategists have made the following observations in support of their market optimism:
The meme above is consistent and pervasive. After all, the crowd usually outsmarts the remnants (except, of course, at inflection points), so it rarely pays to be proactive. Play the trend, don't fight the tape or question the market's rise. And, above all, stay fully invested—if not, you will face career risk.
I would argue that:
For instance:
And the list could go on, but we'll stop it there.
For instance:
Looking at nominal or stated profits (projected at $117 to $120 a share for the S&P 500) rather than normalized earnings (to account for degradation in profit margins) could prove to be a fool's errand, just like the mistake that was made back at the generational bottom (when trailing earnings of only $45 a share understated normalized corporate profitability). At that time in 2009, investors were as reluctant to buy as they are emboldened to buy in 2014.
In summary:
I would strongly consider reducing exposure to the U.S. stock market.