Wednesday, August 8th, 2012
It would appear that the dilemma of the world exporting more than it imports (that we initially pointed out here) is starting to come to a head in reality with a negative export trade shock. As Gluskin Sheff’s David Rosenberg notes, since the recovery began three years ago, over 70% of the real GDP growth we have seen was concentrated in export volumes and inventory investment; and recent data from the ISM (here and here) points to a dramatic slowdown in both. Compounding this weakness is the fact that the remaining growth was from Capex – which is now likely to slow given the weakening trend in corporate profits – and will more than offset any nascent turnaround in the housing sector – if that is to be believed. The consumer has all but stalled and adding up all these effects and there is a high probability of a 0% GDP growth print as early as Q4.
Macro Risks Squarely To The Downside
I think that there may be a time, before too long, when we will walk into the office to find that the US prints a negative GDP reading on the back of a negative export trade shock that does not appear to be in any forecast – let alone consensus.
Look at the pattern of ISM export orders:
- April: 59.0
- May: 53.5
- June: 47.5
- July: 46.5
That is called a pattern. And this is a level that coincided with the prior two recession. As the chart below vividly illustrates, there is a significant 81% correlation between annual growth in total US exports and the ISM new orders index (with a four month lag). So either the market has already priced this in or it is going to end up coming as a very big surprise. We are already seeing the lagged effects of the spreading and deepening European recession hit Asian trade-flows: Korean exports sagged 4.1% in July after a 3.7% slide in June and are down 9% on a YoY basis. Industrial production there edged lower by 0.4% as well last month – I like to look at Korea since it is a real global ‘play’ on the economic cycle.
There is likely going to be another surprise, which is inventory destocking. How do I know that? Because the share of ISM industries polled in July reported that customer inventories were excessively high soared to 33% in July from 11% a year ago (because this metric is not seasonally adjusted it can only be assessed year-on-year), the highest ever for any July in the historical database.
Add to that what is happening to order books – the share of the manufacturers reporting expanded orders sank to 17% in July from 50% a year ago and again – the worst July showing on record.
The food price situation is another major wild card, especially since whatever relief we enjoyed from lower gasoline prices is now behind us. At a 14% share of the consumer spending pie, only shelter is more important than food. And when you go back to the last food cost surge, in the first quarter of 2011 when the grocery bill soared at a punishing 10% annual rate, real GDP growth slowed to a 0.0% annual rate that quarter, which arguably was the big surprise of the year (up until the dent downgrade, that is).
In the final analysis, since the ‘recovery’ began three years ago, over 70% of real GDP growth we have seen was concentrated in these two areas: export volumes and inventory investment. The rest was in capex which is now likely to slow along with the weakening trend in corporate profits, more than offsetting the nascent turnaround in the housing sector. Also keep in mind that the consumer has stalled.
Tally all these effects up and you are looking at the prospects of 0% growth as early as Q4.
Tags: Asian Trade, Capex, Corporate Profits, Correlation, Dalio, David Rosenberg, Downside, Dramatic Slowdown, Export Orders, Export Trade, Export Volumes, GDP, GDP Growth, Gluskin Sheff, Growth Outlook, Inventory Investment, Ism, Korean Exports, Real Gdp, Recession, S David
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Thursday, August 2nd, 2012
by Seth Masters, Chief Investment Officer, AllianceBernstein
Some experts today argue that the world has entered a “New Normal” condition in which stocks have permanently lost their return edge. We’ve heard this before. It was wrong then, and we think it’s wrong now, too.
In 1979, BusinessWeek published a cover story famously called “The Death of Equities.” Then, like now, stock market returns had lagged 10-year Treasury returns for a decade, although for somewhat different reasons.
Stock returns had been dragged down by the bursting of a bubble (the Nifty Fifty) and bleak economic conditions. OPEC had unleashed its second oil-price shock in five years. The so-called misery index—the sum of the unemployment and inflation rates—was 20% in the US, double its level today (because inflation is now very low). And corporate profits were very weak (today, they are very strong).
BusinessWeek was capturing widespread sentiment about the economic and market outlook. Nonetheless, stocks handily beat bonds over the 10 years starting in 1979.
As the ubiquitous legal disclosure says, past performance does not guarantee future returns. Indeed, performance often reverses sharply.
Between 1901 and the onset of the recent credit crisis, there have been 11 10-year rolling periods in which bonds beat stocks, all of them coinciding with the Great Depression or the stagflation of the 1970s. And after each and every one of them, stocks beat bonds for 10 years—on average, by 5.8%, as the Display below shows.
Because we are human, we all tend to expect the future to resemble the recent past—to become “anchored” in our recent experience. It takes guts to buck the trend. But at a September 1983 client conference, we cited good fundamental reasons in making “The Case for the 2,000 Dow.” The Dow Jones Industrial Average was then slightly below 1,300. It reached 2,000 in January 1987, about three-and-a-half years later.
Today, our median annual return projections for global and US stocks are about 8% over the next 10 years, far ahead of our projected 2% median return for 10-year Treasuries. At that rate, the Dow could hit 20,000 in five to 10 years. In the same time frame, the S&P 500, a more representative index, could hit 2,000. (It’s now around 1,300.)
Our projected stock returns may sound optimistic. They’re not. They are well below the long-term average for US and global equities, and are based on conservative assumptions about economic and market conditions.
Still, many pundits argue that stocks today are overpriced. My next blog post will assess stock valuations.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.
Tags: Businessweek, Chief Investment Officer, Corporate Profits, Credit Crisis, Different Reasons, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Fundamental Reasons, Future Returns, Great Depression, Inflation Rates, Legal Disclosure, Market Outlook, Misery Index, Oil Price Shock, stagflation, Stock Market Returns, Stock Returns, Stocks Bonds
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Monday, July 30th, 2012
by John Hussman, Hussman Funds
The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?
Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.
Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate of productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.
Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later. The reality is that Europe is not a unified economic and political entity with a single national character and obligations that are mutualized among its members. It is instead a geographic region where the economic, political and cultural differences remain very distinct. While each country is willing to cooperate in setting common rules and practices that are to their own benefit, they are unlikely to cooperate when it comes to decisions that require the stronger economies to interminably subsidize the insolvent ones through direct fiscal transfers or permanent money creation that has the same effect.
With regard to last week’s ebullience over the possibility of ECB buying of sovereign debt, my concern continues to be the danger of assuming that a solvency problem can simply be addressed as a liquidity problem. If the European Central Bank buys Spanish or Italian debt in volume, there is very little likelihood that it will ever be able to disgorge this debt. This is because: any eventual ECB sales of debt holdings – or failure to roll those holdings over – will have to be offset by private demand in the same amount, when Spanish and Italian debt/GDP ratios are unlikely to be smaller; the European banking system is already largely insolvent, and; the European continent is already in recession, which means that the volume of distressed sovereign debt is likely to expand even beyond the reasonable capacity of the ECB to absorb it. So major ECB purchases would effectively amount to money-printing, and Germany, Finland and other countries in opposition are fully aware of that. Reversible liquidity operations may be monetary policy, but non-reversible money-printing is quite simply fiscal policy.
For a review of some of the issues the ECB faces, see Why the ECB Won’t (and Shouldn’t) Just Print. In evaluating the repeated assurances that emerge out of Europe, keep in mind that details matter. For example, the phrase “Germany is prepared to do everything that is necessary to defend the Euro” has repeatedly meant “everything that is politically necessary” and “everything that is legally required.” It has also been demonstrated again and again that Germany (among other stronger European countries) has no intention of allowing a blank check for direct EFSF or ECB bailouts without a change in the EU law that imposes a surrender of fiscal sovereignty and centralized fiscal control of Euro member countries. Following Thursday’s assurances by ECB head Mario Draghi to protect the Euro (just after Germany’s Angela Merkel left on a hiking trip), it took until Saturday for the German finance minister to step into the void with the predictable, “No, these speculations are unfounded.” It was widely reported that Germany again tossed out the “everything that is necessary” bone on Sunday, but one had to read the French dispatch to find that this accord referred to nothing but an agreement between Germany and Italy to do everything necessary to quickly implement June’s plan for a plan to establish a centralized banking regulator: l’Allemagne et l’Italie sont d’accord pour “que les conclusions du conseil européen des 28 et 29 juin soient mises en oeuvre aussi rapidement que possible.”
In the U.S., quantitative easing has had the effect of helping oversold financial markets recover or slightly surpass the peak that the S&P 500 Index achieved over the preceding 6-month period, but there is much less evidence that it will do much for the financial markets when prices are already elevated and risk-premiums already deeply depressed (see What if the Fed Throws a QE3 and Nobody Comes?). The upper Bollinger band of the S&P 500 on both weekly and monthly resolutions is at about 1430. That level represents our best estimate for the market’s upside potential in the event that the Federal Reserve initiates a third program of quantitative easing. Given that our economic measures continue to indicate that the U.S. has entered a new recession, it is not clear that another round of QE will even achieve that effect.
In the event that another round of QE has a greater or more durable effect, we’ve introduced enough additional constraints on our staggered-strike hedges that we wouldn’t expect the decay in option premium that we experienced during QE2. The market reestablished an “overvalued, overbought, overbullish” syndrome last week, so another round of QE is unlikely to move us to a significantly constructive investment stance as long as that syndrome is in place. Still, we don’t expect to move our strike prices higher in the event of further improvement in market internals, so the “tight” character of our present hedge will moderate in the event the market advances from here. Suffice it to say that I’m not worried that another round of QE will create difficulties for our approach, though it should also be clear that such an event wouldn’t automatically prompt us to shift to a bullish investment stance.
What worries me most
Investors sometimes ask what I worry about most from the perspective of our investment strategy. Do I worry that the Fed will initiate another round of QE and distort the markets to such an extent and duration that our approach will not capture new realities? Do I worry that government interventions have created a world where old economic rules and relationships no longer apply? Do I worry about the quality of government statistics or the potential for misreporting or seasonal adjustment distortions in the data we use? The answer is that all of these issues can exert a short-run influence on the course of our investment approach, but none of them alter the relationship between valuations and long-term returns, and I don’t expect any of them to significantly reduce the effectiveness of our strategy over the complete market cycle.
As I noted as the market approached its highs a few months ago, what I worry about most is that conservative investors will become impatient with maintaining a defensive position in a dangerous and elevated market – not because investment prospects have materially improved, but simply because short-lived runs of speculative relief seem too enticing to miss. Volatile but ultimately directionless periods of elevated valuations, as we saw in 2000-early 2001, 2007-early 2008, and which we’ve observed since April 2010, tend to exhaust defensive investors and encourage complacency toward market risk at the worst possible time.
Certainly, for our shareholders in Strategic Growth Fund, I’ve compounded this impatience, because our “miss” in 2009-early 2010 – which I would not expect to be repeated in future cycles even under identical conditions – blends in with our defensiveness since early-2010, which aside from a few differences related to option positions, I would expect to be repeated in future cycles under identical conditions. The result is one long period of defensiveness, which understandably leaves those unfamiliar with that 2009-early 2010 period with the assumption that our approach will never be constructive.
I view these weekly comments as something of a conversation with shareholders, so I do my best to address questions that come up more than once or twice in a short period of time. In Strategic Growth Fund, understanding performance in recent years is one of those questions, so I ask the indulgence of shareholders who have walked through this discussion before, and I hope that the comments are useful even for those that have. Thanks.
Let’s first address the period since early 2010. Given the policy of central banks in recent years to provide what amount to free put options to investors, there are certainly ways we could have saved a few percent in actual put option premium (incorporated in our present methods as added criteria related to trend-following measures). But the fact is that the S&P 500 Index was within 5% of its April 2010 peak only a few weeks ago, and there remains a strong risk that the market will move significantly below that level in the months ahead. From a historical standpoint, the conditions we’ve seen since early-2010 have warranted a generally defensive position, and the negatives have accelerated significantly in recent months. We would expect to adopt a similarly defensive position again in future cycles under the same conditions. The only way to get around that would to be to take actions that would have produced significant losses if they were taken regularly on a historical basis.
Unfortunately, the warranted and repeatable defensiveness we’ve adopted since 2010 blends in with a non-recurring intervention during 2009-early 2010 (which I discussed regularly during that period) to ensure that our hedging approach was robust to Depression-era data.
Recall that this intervention was not driven by any problem with the performance of our investment approach. Indeed, by the beginning of 2009, a dollar invested in Strategic Growth Fund at its inception in 2000 had grown to about four times the value of the same investment in the S&P 500 Index. The Fund was ahead of the S&P 500 at every standard and non-standard investment horizon, with dramatically smaller losses. For example, from the 2007 stock market peak, the S&P 500 Index had suffered a peak-to-trough loss of 55.25%, while the deepest loss experienced by Strategic Growth Fund was 21.45%. To put that difference in perspective, note that simply moving from a 55.25% loss to a 21.45% loss requires an offsetting recovery of 75.53%. It takes extraordinary good fortune to recover from deep drawdowns, which is why we make such an effort to avoid them.
Still, as the credit crisis worsened in 2009, it became clear that both the economy and the financial markets were behaving in ways that were “out of sample” from the standpoint of the post-war data on which our existing return/risk estimates were based. That kind of situation demands stress-testing; a concept that too few investors take seriously until it’s too late. I took our existing approach to Depression-era data and found that though it performed reasonably well over the full period from a return perspective, it also allowed a number of very deep interim losses before recovering. Even though our approach had performed well, a Depression-like outcome could not be ruled out (and to some degree still can’t), so I insisted that our methods should be robust to “holdout” data from both the Depression era and the post-war period. I discussed that challenge repeatedly in the weekly comments and annual reports as our “two data sets” problem. We reached a satisfactory solution in 2010 through the introduction of ensemble methods in our hedging approach. But by that point, we had also missed a significant market rebound.
The result has been my elevation to the title of Permabear, Doomsayer, and other lovely aliases. It’s kind of tragic that I both lessened my reputation and missed returns for shareholders – though I expect only temporarily – because of what I viewed (and continue to view) as fiduciary duty. At least shareholders can be sure that I’ll never knowingly lead them down a rabbit hole. While we have – apart from the most recent cycle – been successful in strongly outperforming the market over complete cycles (bull-peak to bull-peak, bear-trough to bear-trough) with substantially smaller drawdowns, it’s important to recognize that we do have a much greater tolerance for tracking differences versus the S&P 500 over the course of the market cycle than some investors can accept. Our investment approach is simply not appropriate for those investors. Significant tracking differences will occur again and again over time, because they are inherent in our approach, particularly in the richly-valued portion of a given market cycle.
Meanwhile, I’m confident that that our stress-testing miss during the most recent cycle (which works out to a cumulative lag of just under 13% over the peak-to-peak market cycle from 2007-2012) is something we can more than offset in future cycles. Also, given our willingness to remove the majority of our hedges in early 2003 at valuations that were in no way compelling from a historical standpoint, it should be clear that we don’t require Armageddon to adopt a constructive or even aggressive investment stance.
So what do I worry about? I worry that investors forget how devastating a deep investment loss can be on a portfolio. I worry that the constant hope for central bank action has given investors a false sense of security that recessions and deep market downturns can be made obsolete. I worry that the depth of the recessions and downturns – when they occur – will be much deeper precisely because of the speculation, moral hazard, and misallocation of resources that monetary authorities have encouraged. I worry that both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention.
Our measures of prospective stock market return/risk deteriorated slightly last week, from the most negative 0.8% of market history, to the most negative 0.6%. These are minor distinctions, of course, but it is important to emphasize how rare and negative present conditions are from a historical standpoint. I recognize that many analysts consider stocks to be cheap on the basis of “forward operating earnings,” but I continue to believe that the 50-70% elevation in profit margins relative to historical norms is an artifact of extreme deficit spending and depressed savings rates, and that as a U.S. recession unfolds, profit margins and forward earnings estimates will collapse. This is currently seen as heresy (as was my assertion just before the tech-collapse that technology earnings would turn out to be cyclical), but that’s how earnings and profit margins work.
Looking out anywhere from 2 weeks to 18 months, our measures remain very defensive, with the worst horizon being about 7 months out. Additional firming in market action from here would modestly improve our near-term measures of prospective return (which are more dependent on trend-following factors), but would generate little improvement beyond a horizon of several weeks. Meanwhile, our estimate of prospective 10-year S&P 500 total returns (nominal) is now only 4.7%. This figure may seem appealing relative to a 1.5% yield on 10-year Treasury bonds, but as I’ve noted before, you don’t “lock in” a long-term return on an investment; you ride it out over time. My expectation is that this ride will be extremely uncomfortable for passive buy-and-hold investors over the coming decade, and that there will be numerous opportunities to accept both stock and bond market risk at substantially higher prospective returns.
Strategic Growth and Strategic International remain tightly hedged, Strategic Dividend Value remains hedged at about half of the value of its holdings – its most defensive stance, and Strategic Total Return continues to carry a duration of about one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.
Tags: Austerity, Bad Debt, Brink, Corporate Profits, Debt Reduction, Draghi, Economic Growth, Economic History, Economic Problem, Economic Recessions, Evidence To The Contrary, Financial Institutions, Financial Markets, Fluctuations, Full Force, Government Debt, Hussman, Hussman Funds, John Hussman, Public Debt, Receivership
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Wednesday, July 11th, 2012
Could “Confidence” Add 50 Percent to the Stock Market?
by James Paulsen, Chief Investment Strategist, Wells Capital Management
Fear (a lack of confidence) has dominated the economic and investment climate since the 2008 crisis. Indeed, excessive fears during the crisis likely accentuated the magnitude of the economic collapse far more than did poor economic fundamentals alone. Similarly, the inability to revitalize confidence since has also hampered both the economic and stock market recoveries.
A culture devoid of confidence has proved a chronic liability during the last five years. However, could a slow but steady revival in confidence soon become a primary asset driving stock prices higher? For a third time in the post-war era, since 2008, the U.S. stock market has traded below its long-term trendline level (that is, the level of the stock market if it rose through time at a constant pace equal to its long-term average return). While the slope of the stock market’s trendline tends to approximate the sustainable earnings growth rate, the degree to which the stock market trades above or below its trendline level has depended primarily on economic confidence. As shown below, should confidence simply rebound to a normal recovery level in the next several years, the return of the U.S. stock market may be boosted by 50 percent!
Post-War U.S. Stock Market vs. Trendline
Charts 1 and 2 compare both the U.S. stock market and U.S. corporate earnings relative to their respective post-war trendline levels. In each case, the trendlines are calculated by a simple regression of the (natural log) level of the stock market or profits against time. The slope of each trendline is a proxy for the average annualized growth rate over the entire period. Not surprisingly, since stock prices respond to earnings, the trendline slope of corporate profits and of the U.S. stock market are nearly identical at about 7 percent. And, 7 percent is very close to the annualized growth in nominal GDP—since 1949, nominal GDP growth has averaged about 6.7 percent overall. Essentially, over long periods of time, earnings cannot grow faster than overall economic growth and the buy and hold price only return from the stock market approximates the long-term pace of earnings growth.
Is Historic Earnings Trendline a Good Guide to Future?
In the post-war era, the annualized total return from stocks has been about 11 percent comprised by about 7 percent earnings growth and about 4 percent dividend returns. As shown in Chart 1, however, in the last decade, the stock market has significantly trailed relative to its trendline. Is the old trendline growth rate of about 7 percent still a reasonable expectation for the future?
Certainly, U.S. balance sheets are more leveraged today and the savings rate has been far lower in recent years compared to earlier in the post-war era. Moreover, aging U.S. demographics almost ensures slower labor force growth in future years (a moderating force for overall economic growth) unless immigration policy is considerably liberalized. Alternatively, in the last couple decades, the global economy has created a fabulous new economic growth booster—functioning emerging world economies! So far, these new economic entities have mainly augmented supply capabilities but several are on the cusp of becoming burgeoning middle class economies which should dramatically boost global demand and perhaps help maintain global economic growth rates even as developed economies age.
Most encouragingly, however, as shown in Chart 2, U.S. earnings continue to follow the long-term trendline established throughout the post-war era. Despite noticeably slower average GDP growth in the U.S. since 1985, earnings growth has continued to approximate its historic long-term trendline. Indeed, despite the pronounced and ongoing concerns surrounding the contemporary recovery, U.S. earnings bounced quickly above trendline after the recession and have since risen in line with trendline growth. Overall, earnings show no signs yet of breaking below long-term results suggesting the long-term trendline for the stock market may remain near post-war norms.
The Valuation of the Earnings Trend
Although stocks are ultimately tethered to earnings, in the short-run, the stock market often trades at a premium or discount to its trendline. As illustrated in Chart 1, the difference between the stock market and its long-term trendline is a good proxy for investors’ valuation of the long-term earnings trend. Since 2008, for the third time in post-war history, the U.S. stock market has traded persistently “below” its trendline. This also occurred after WWII until the mid 1950s, and again between the early 1970s until the late 1980s.
This is also illustrated in Chart 3. What causes investors to value the earnings trend sometimes at a 25 percent (or more) premium and sometimes at a 25 percent (or larger) discount? Certainly, multiple factors comprise this complicated valuation. During the late 1940s, the discount to trendline seemed to be driven by a post-war inflation surge, in the 1970s escalating inflation and interest rates appeared to lower valuations, and in the contemporary period persistent anxieties surrounding the potential for a global financial calamity have dominated. By contrast, the huge premium paid by investors for trendline earnings in the 1960s coincided with attitudes reflected in the “Camelot Kennedy Years” while the record-setting premium valuation reached in the late 1990s was a product of a “new-era” mania.
Confidence & Valuations
As shown in Chart 4, the discount or premium valuation of the stock market relative to its trendline is perhaps best explained by economic “confidence.” This chart overlays the percentage differential of the stock market relative to its trendline with the consumer confidence index. Although not a perfect relationship, the level of confidence has done a good job tracing changes in the “valuation of the earnings trend” during the post-war era.
Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear. Currently, U.S. economic confidence is hovering in the lowest quartile of its post-war range and the U.S. stock market is about 25 percent below its trendline. This is not a coincidence. As was the case in the late 1940s, early 1950s, and again in the 1970s, early 1980s, a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!
An Investment Possibility?
The confidence index illustrated in Chart 4 has oscillated between about 60 and 110. With the exception of the late 1990s when the index briefly reached above 110, “normal” economic recovery confidence peaks have been around 100. Stock investors should consider what could happen should confidence slowly recover to normal again in the next five years eventually reaching a level between 95 and 100. Using history as a guide (reading across to the left scale in Chart 4), if confidence returns to normal, the stock market would likely trade at a 25 percent to 30 percent premium to its trendline level.
Of course, in five years, the stock market trendline level will also be higher. If the historic trendline growth rate remains a good guide for the future, the trendline (the dotted line) in Chart 1 would rise by about 7 percent a year in the next five years suggesting a trendline by 2017 of about 2425. However, to be conservative, assume in the next five years trendline earnings only grow at a pace of 3 percent, significantly “less” than the long-term trendline growth rate of 7 percent. Currently, the S&P 500 trades at about 1350 and its trendline level (from Chart 1) is about 1800 (i.e., 25 percent higher than the S&P 500 current price of 1350). With these assumptions, the stock market trendline would rise by 16 percent in five years to about 2100!
Finally, from Chart 4, assume confidence improves from its current level to about 95 boosting the investor valuation of the trendline from its current 25 percent discount to about a 25 percent premium in five years. A trendline target in five years of about 2100, combined with a valuation premium of about 25 percent implies a target price for the S&P 500 of about 2600—nearly a double from today’s level!
While we are not forecasting a doubling of the stock market during the next five years, this analysis does highlight the longer-term upside potential from stocks which exist today solely because of widespread cultural fears. Chart 3 shows the stock market has a historical tendency to oscillate between periods of glee and gloom.
The eventual impact of the Great Depression and WWII on investor attitudes kept the stock market selling at a discount until the late 1950s. By contrast, the cultural euphoria which swept the country during the baby-boom years kept stocks oscillating about a 25 percent premium between the late 1950s and the early 1970s. The stock market could be bought at a 60 to 70 percent discount in the 1970s when runaway inflation and interest rates destroyed confidence. Twenty years later in the late 1990s, investors could not buy stocks fast enough in the “new-era” even though they paid a 60 to 70 percent premium! Since 1945, two bouts of cultural glee (1960s and 1990s) subjected investors to significant risks while recurring bouts of cultural gloom have treated investors with three remarkable “fire sales”—1940s, 1970s, and “today”! Stock prices will continue to oscillate and scary sell-offs will occasionally feed fears, but don’t miss this sale!
Tags: Chief Investment Strategist, Corporate Earnings, Corporate Profits, Earnings Growth, Economic Collapse, Economic Confidence, Economic Fundamentals, Investment Climate, Lack Of Confidence, Post War, Simple Regression, Slope, Steady Revival, Stock Earnings, Stock Prices, Third Time, Trendline, Trendlines, U S Stock Market, Wells Capital Management
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Tuesday, June 5th, 2012
by Douglas Coté, ING Investment Management
- Disappointing U.S. economic data combined with continued concern about the fate of Europe to send investors fleeing to safety. Global equity markets fell to finish off a brutal May, while benchmark tenyear U.S. Treasuries hit a new all-time low of 1.46%. The German two-year bond yield fell below 0%, meaning investors preferred a guaranteed loss to the uncertainties of holding other securities.
- First quarter economic growth was restated down to 1.9% from the previous estimate of 2.2%, as inventory building and government spending were markedly weaker than expected. Corporate profits, however, posted their largest quarterly gain since fourth quarter 2009.
- Jobs data were disappointing. Nonfarm payrolls came in at 69,000 for May, far short of the 155,000 economists had expected. Separately, ADP reported the addition of only 133,000 private sector jobs; the consensus estimate had been 150,000. New unemployment claims increased for the fourth consecutive week, while the unemployment rate rose from 8.1% in April to 8.2% in May. Median unemployment duration rose to over 20 weeks, with 43% of the unemployed out of work more than six months.
- Pending home sales in the United States unexpectedly fell to a four-month low, tempering some of the recent positive data in the housing market. Meanwhile, the Case-Shiller home-price index ended March at its lowest level since the housing crisis began.
- Though investors took comfort in a survey suggesting that Greece may be able to form a government following its June 17 elections and abide by its bailout plan, the situation in Spain grew more precarious, sending yields on Spanish debt close to euroera highs. Bankia, the country’s third-largest bank, has asked for government assistance to the tune of €19 billion, and a number of other banks are also thought to need recapitalization.
- The Indian economy grew at its slowest pace in almost ten years during the first quarter. GDP growth of 5.3% fell short of the consensus estimate of 6.1% as both the manufacturing and agricultural sectors foundered.
Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. Past performance is no guarantee of future results.
Copyright © ING Investment Management
Tags: agricultural, Bailout Plan, Bond Yield, Case Shiller Home Price Index, Consensus Estimate, Corporate Profits, Economic Data, Eurozone, Fourth Quarter, Global Equity Markets, Government Assistance, government spending, Home Price Index, Housing Market, India, Indian Economy, Ing Investment Management, Nonfarm Payrolls, Recapitalization, Treasuries, Unemployment Duration, Unemployment Rate
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Monday, May 7th, 2012
by Douglas Coté, Chief Investment Strategist, ING Investment Management
The bears grew hopeful early in the month, as global markets were spooked by goings-on in the euro zone: Spain briefly brought back fears of bailout Armageddon, the Dutch government collapsed, and PMI numbers for the region came in weaker than expected. April Fools! The bull market remains intact and offers compelling value for those looking to build wealth.
At its April trough, the S&P 500 was down 3.5% for the month. However, the bull awoke mid-April, prodded by relentless corporate strength that continues to confound Wall Street. Blockbuster corporate profits were led by financials, followed by industrials and put over the top by technology. With a meager 0.89% consensus expectation for first quarter earnings growth, Wall Street got it wrong; in fact, considering that first quarter earnings growth, at press time, stands at an explosive 8.8%, “got it wrong” is a serious understatement. The S&P 500 surged into the end of the month, making up nearly all its lost ground.
This performance is no joke for those who are missing out on an extraordinary bull market that has just entered its fourth year. It is not too late for savers to turn into investors, but this market’s persistent and determined march forward will not wait for the hesitant. Investors must resist the all-ornothing approach to risk; a moderate risk posture has been handsomely rewarded over the past three years despite pockets of extreme volatility.
The questions for investors to ask are how and when to invest. We get into the “how” below. The answer to “when” is more straightforward — immediately! Don’t delay, because every day is a good day to invest during a bull market.
Tags: April Fools, Armageddon, Bailout, Blockbuster, Chief Investment Strategist, Corporate Profits, Corporate Strength, Dutch Government, Earnings Growth, Euro Zone, Extreme Volatility, Fourth Year, Global Markets, Global Perspectives, Industrials, Ing Investment Management, Moderate Risk, Press Time, Quarter Earnings, Stampede
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Monday, April 30th, 2012
by John P. Hussman, Ph.D., Hussman Funds
Over the past 13 years, and including the recent market advance, the S&P 500 has underperformed even the minuscule return on risk-free Treasury bills, while experiencing two market plunges in excess of 50%. I am concerned that we are about to continue this journey. At present, we estimate that the S&P 500 will likely underperform Treasury bills (essentially achieving zero total returns) over the coming 5 year period, with a probable intervening loss in the range of 30-40% peak-to-trough.
Why? First, with respect to 5-year prospective returns, it’s important to recognize that returns at that horizon are primarily driven by valuations – not the “Fed Model” kind, but the normalized earnings and discounted cash flow kind. Stocks remain strenuously overvalued here, and only appear “fairly priced” relative to recent and near-term earnings estimates because corporate profit margins are more than 50% above their long-term norm. Meanwhile, corporate profits as a share of GDP are about 70% above the long-term average. As I detailed in Too Little To Lock In, these abnormally high margins are tightly related (via accounting identity) to massive fiscal deficits and depressed household savings rates, neither which are sustainable.
Our projection for 10-year S&P 500 total returns – nominal – is about 4.4% annually, which is far better than the 2000 peak, far inferior to the 2009 trough, and save for the period before the 1929 crash, worse than any prospective return observed prior to the late-1990′s bubble – even in periods having similarly depressed interest rates.
Of course, rich valuations can persist for some time – predictably resulting in poor long-term returns, but often doing little to prevent short-run speculation and temporary gains. The issue is then to identify the point at which overvalued conditions are joined by sufficiently overextended conditions, and a sufficient loss of speculative drivers, to make rich valuations “bite” even in the shorter-term. This is where additional criteria come in, such as overbought technical conditions and extreme optimism in the form of low bearish sentiment, depressed mutual fund cash levels, and heavy insider selling. Presently, it doesn’t help that T-bill yields and long-term bond yields remain higher than 6 months ago, and we have signs of oncoming recession. This is particularly evidenced by collapsing economic measures in Europe, softening economic performance in developing economies including China and India, and jointly weak year-over-year growth in key U.S. economic measures such as real personal income, real personal consumption, real final sales, and reliable leading indicators from the OECD and ECRI, as well as our own measures.
The combination of rich valuations, overbought conditions, overbullish sentiment, and deteriorating leading economic evidence can still unfortunately persist for months before being resolved. But once the hostile syndromes we’ve seen recently have emerged in the data, attempts at continued speculation have amounted to playing with fire. Similar conditions have repeatedly resulted in disastrous outcomes for investors. It would be nice to be able to “time” these outcomes better. We haven’t found a reliable way to do so, and would still be concerned about robustness – sensitivity to small errors – even if we did. Yet even when unfortunate outcomes are not immediate, the fact that the S&P 500 has underperformed T-bills for 13 years is not very sympathetic to arguments that stock market risk has been worth taking overall, except in confined doses.
Tags: Corporate Profit, Corporate Profits, Discounted Cash Flow, Earnings Estimates, Fed Model, Fiscal Deficits, GDP, Household Savings, Hussman Funds, Kraken, Market Advance, Market Plunges, Model Kind, Profit Margins, Speculation, Term Earnings, Treasury Bills, Trough, Valuations
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Tuesday, April 10th, 2012
by Dr. Scott Brown, Ph. D, Chief Economist, Raymond James
April 9 – April 13, 2012
The stock market has risen nicely this year, partly on improving economic data, but are such gains justified by the earnings outlook? The level of the S&P 500 Index does not appear to be out of line with earnings expectations, but there may be some pressure on profits over the longer term. As the election approaches, we may hear more about class warfare.
In the late 1990s, share prices rose more than was justified by the earnings outlook. In hindsight, the market was clearly in a bubble. In the last decade, the market rose roughly in line with earnings. However, the Great Recession sent earnings sharply lower, and the stock market followed. Since the recession has ended, earnings have more than recovered. Bottom-up earnings estimates for more than a year out, compiled from analysts’ forecasts of individual companies, still look a bit giddy, but that’s typical. Top-down estimates, provided by economists and strategists, are more moderate – and consistent with some slowing in corporate earnings relative to the last few years. That’s to be expected. Much of the rebound in earnings has reflected the bounce-back from the recession. Firms have a tendency to cut too many jobs and overly curtail capital expenditures near the end of the downturn and there’s some catch-up as conditions begin to improve.
Part of the strength in corporate profits in the recovery has been due to the restraint in labor costs. Given the large amount of slack in the labor market, wage pressures are relatively subdued. Moreover, since the labor market slack is expected to remain elevated for some time, corporate profits are likely to stay relatively strong. As a percentage of national income, corporate profits are very high and labor compensation is relatively low. The share of national income going to profits and the share going to labor cycles back and forth over time and at some point the pendulum seems likely to swing back in the other direction, but probably not anytime soon.
It’s hard to have an intelligent discussion about the distribution of income. One side sites “corporate greed,” the other sites “class envy.” For the most part, economists have generally shied away from income distribution issues. This is mostly a question of politics. It’s difficult to say what an “appropriate” distribution of income should be and what steps should be taken to achieve it.
However, there’s no doubting that the distribution of income has widened significantly over the last thirty years. Real wages have stagnated. A lot of that is due to the decline of union membership. In the early 1970s, 25% of private-sector jobs were union jobs. Now unions account for less than less than 7% (note that 37% of public-sector jobs are union, but many of these are teachers and the dynamics are a lot different). In the late 1960s and early 1970s, we typically had more than 300 work stoppages per year, involving millions of workers. We had 19 last year, involving 113,000 workers.
It’s unclear what role the distribution of income will take in this year’s election, but investors should pay attention.
Tags: Capital Expenditures, Chief Economist, Class Warfare, Corporate Earnings, Corporate Profits, Downturn, Dr Scott, Earnings Estimates, Economic Data, Hindsight, Individual Companies, Labor Compensation, Last Decade, Raymond James, Recession, Share Prices, Slack, Stock Market, Strategists, Wage Pressures
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Tuesday, April 10th, 2012
by Douglas Coté, ING Investment
We just wrapped up the best first quarter since 1998, volatility has dropped to almost boring levels, fundamentals are relentlessly marching forward and global risks appear to have returned to a morenormal state.
To the astonishment of the bears, volatility, inflation and global risk are down while profits, employment and manufacturing are up — and markets have been gaining momentum with an aura of sustainability. Could it be that the vicious cycle of the past few years has been broken? Could we have entered into the type of virtuous cycle in which positive data beget more positive data, as has marked prior sustained bull markets?
“Sell in May and go away” and other bear strategies that have worked in prior years will likely be ineffective this year, driven in large part by strong fundamentals and global risks that have been excessively discounted.
Fundamentals Remain the Key to Market Success
Our “ABCDs” of fundamentals are the primary drivers of markets but have been slow to capture investor attention. This oversight has created an investment opportunity given the compelling strength in all of these drivers.
Advancing corporate profits. Fourth quarter earnings season started with a few significant misses and a lot of handwringing in the media before momentum ultimately picked up, driving double-digit year-overyear earnings growth. Sales growth was not too shabby either, with top-line revenue growth of 8.3%. The media may lament the deceleration of earnings growth, but we are, after all, continually setting the bar higher — corporate earnings reached an all-time high in 2011, and we expect a new record in 2012.
Broadening manufacturing. U.S. manufacturing has reemerged as a powerhouse, with the ISM manufacturing index expanding for 31 consecutive months. Who says “made in the U.S.A.” is fairytale of yore? Despite the rise of China and other emerging economies, the U.S. still contributes 20% to the world’s manufacturing pie; if the U.S. manufacturing sector was a country, it would be larger than Canada, India or Russia. The emerging countries have been playing catch-up, but as their wage levels increase and their productivity levels tail off, their advantage markedly decreases. Couple that with the fact that the U.S. is number one in productivity, and we say “game on”.
Manufacturing powers the entire economy
— the Bureau of Economic Analysis calculates that every $1 of manufacturing GDP drives an incremental $1.42 of economic activity in nonmanufacturing sectors.
Consumer strength underestimated. A variety of data points suggest the consumer is emerging as a game-changer. The unemployment rate, at 8.3%, is at its lowest level in three years, and the leading employment indicator, initial unemployment claims, are at 2008 lows. While high gas prices may take a bite out of consumer paychecks, it is more important that consumers are actually receiving paychecks. Personal income and personal consumption expenditures have reached all-time highs. February retail sales again surpassed the $400 billion mark to reach the highest monthly level ever. Even housing has shown signs of life, with the best January/February in five years.
Developing economies are driving global growth. Emerging markets continue to be a key catalyst for U.S. corporate revenue. With signs of a potential hard landing in China, there are concerns that weakness in this important corporate growth catalyst may put the bull market in jeopardy. No way — any slowing in China and other emerging markets will be picked up by the “frontier” or newly emerging markets. Indonesia is a good example. Indonesia, the fourth most populous country in the world, recently made headlines when its sovereign debt was upgraded to investment grade. But other good news abounds for the archipelago.
Indonesia is the largest economy in Southeast Asia and grew by 6.5% in 2011, the fastest pace in 15 years. Although 60% of their GDP is fueled by emerging middle-class consumers, Indonesia is also basking in the light of global trade as a large exporter of oil, natural gas, coal and palm oil, and it is home to the second-largest copper mine in the world.
Global Risks Continue to Wane
Europe’s PIIGS (Portugal, Ireland, Italy, Greece and Spain) remain in the news — the latest speculation is that Spain will need bailout funds to effectively recapitalize its banks. We agree. Spain is no Greece, however, and has taken strong austerity measures to contain its crisis. Spanish Prime Minister Mariano Rajoy recently announced €27 billion in budget cuts in a bid to convince the troika of the European Commission, European Central Bank and International Monetary Fund that Spain has its house in order. Alas, these troubled European countries have tended to underestimate their problems, while the market tends to overestimate their impact on the global economy with excessive worry.
The worry is unjustified. The effective fence around the European debt crisis was further bolstered at the end of March with a €700 billion boost to the permanent €500 billion European Stability Mechanism (ESM). This latest round of funding, while maybe not as ambitious as some would have liked, proves that European leaders are willing to do whatever it takes to stem the tide of contagion. Additionally, as the firewall around Europe gets stronger, it opens the door for the IMF to step in, as other countries have pledged to help contain the crisis if Europe takes those first concrete steps.
Why a Market Rally Is a Risk
There is a bigger risk looming on the horizon, bigger than all of the global and geopolitical risks omnipresent in the media. The biggest risk facing investors is a sustained, pronounced U.S. market rally — while they continue to watch from the sidelines. As equity markets move higher month after month, there remains a cadre of wouldbe investors sidelined by lingering fears of an event — i.e., the 2008 Credit Crisis — that has been over for three full years.
We get it: The credit crisis was the worst market disaster since the Great Depression. But since March 2009, the market’s postcrisis bottom, investors have missed out on double-digit equity and fixed income returns; in fact, the S&P 500 has returned almost 100% since March 2009. Many investors have downgraded themselves to “savers” by cowering in cash — $7.5 trillion to be exact
— as they wait for the dust to settle, missing a golden opportunity to build wealth.
We believe the next phase of the market rally will be driven by savers that are compelled to “capitulate” (or “throw in the towel”) and get back into the market due to a fear of being left behind. This fear is warranted; the S&P 500 is trading at a very compelling priceto- earnings ratio (P/E) of only 13.5, relative to its historical average of 15.0. An expansion of the P/E multiple to the historical average would send the S&P 500 to an all-time record high of 1575 at our earnings target of $105 per share. Compare this to a Treasury bond, which at a yield of 2% is selling at the equivalent of a 46 P/E ratio.
Historically cheap valuations are icing on the cake. Global risks are always looming, but we believe investors need to put fear aside, grab a red cape and jump into the ring with this raging bull.
This commentary has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.
The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
Past performance is no guarantee of future results.
©2012 ING – 230 Park Avenue, New York, NY 10169
Tags: Abcds, Bull Markets, Corporate Earnings, Corporate Profits, Deceleration, Earnings Growth, Earnings Season, Emerging Economies, Fourth Quarter Earnings, Gaining Momentum, Global Risk, Global Risks, Ing Investment, Investment Opportunity, Investor Attention, Ism Manufacturing Index, Market Success, Rise Of China, Vicious Cycle, Virtuous Cycle
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Monday, April 2nd, 2012
Too Little to “Lock In”
by John P. Hussman, Ph.D., Hussman Funds
We’ve regularly observed that corporate profit margins (and economy-wide, profits as a share of GDP) have a strong tendency to “mean revert” over time – specifically, elevated profit margins are associated with unusually weak earnings growth over the following 5-year period, and depressed profit margins are associated with unusually strong earnings growth over that horizon (see last week’s comment, A False Sense of Security ). Notably, the ratio of corporate profits to GDP is presently nearly 70% above its historical norm. Of course, the most common valuation methods used by Wall Street analysts (whether they use the “Fed model” or “forward operating earnings times arbitrary P/E multiple”) rely almost exclusively on estimates of year ahead earnings. Embedded in these toy models is the quiet assumption that current profit margins will be sustained indefinitely.
By contrast, a wide range of measures that use “normalized” fundamentals of one form or another are extraordinarily stretched. Andrew Smithers recently took note of the elevated levels of cyclically adjusted P/E ratios and price to replacement cost (“q”) and observed “As of 8th March, 2012, with the S&P 500 at 1365.9 , the overvaluation by the relevant measures was 48% for non-financials and 66% for quoted shares. Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.”
At 1400 on the S&P 500, the market’s overvaluation has now reached 70% on these measures, which have a far stronger correlation with subsequent market returns than the Fed Model or other unadjusted methods using forward operating earnings. This is particularly true over horizons of 4 years or longer. As a side note, since the reliance on forward operating earnings is now an established Wall Street practice, Valuing the S&P 500 Using Forward Operating Earnings details how to improve the reliability of market valuations based on these figures.
We presently estimate a nominal total return on the S&P 500 averaging 4.1% annually over the coming decade. This modestly exceeds the yield available on a 10-year Treasury, but by a small margin that – outside the late 1990′s bubble period – has previously been seen only during the two-year period approaching the 1929 peak, between 1968-1972 (which was finally cleared by the 73-74 market plunge), and briefly in 1987, before the crash of that year.
While it’s true that interest rates are depressed, apparently setting a low “bar” for equities, an additional question one should ask is whether interest rates themselves are “fair” in the sense of being adequate compensation for long-horizon risks. For example, back in 1982, stocks had a reasonable 10-year prospective risk-premium versus bonds, but both were priced to achieve extraordinarily strong returns. Presently, stocks have a weak 10-year prospective risk-premium versus bonds, but both are priced to achieve unsatisfactory returns. In 1982, investors had an incentive to lock in either, and were served well regardless of their choice. At present, investors have no reasonable incentive at all to “lock in” the prospective returns implied by current prices of stocks or long-term bonds (though we suspect that 10-year Treasuries may benefit over a short horizon due to continued economic risks and still-unresolved debt concerns in Europe, which has already entered an economic downturn).
It’s also inadvisable to view the present 4.1% projected (nominal) 10-year return on the S&P 500 as if it is some sort of “yield,” because even that expected return involves the risk of significant volatility and severe short-horizon loss.
But don’t low interest rates at least limit the potential downside in stocks, allowing stocks to remain at elevated valuations that are consistent with similarly low prospective returns? On that question, the historical record is instructive. Since 1930, the 10-year Treasury yield has been below 3% nearly 30% of the time. In 78% of those periods, the prospective 10-year total return on the S&P 500 exceeded 10% (based on our standard estimation method). In fact, the 10-year Treasury yield has historically been below 2.5% about 15% of the time (primarily in the period prior to 1952) and in fully 94% of those periods, the prospective 10-year total return on the S&P 500 exceeded 10%. The belief that prospective equity returns are tightly linked to bond yields is largely an artifact of the 1980-1998 period (when both enjoyed a persistent decline during a long period of disinflation), and is far less evident in broad market history.
Ignore the fact that long-term “secular” bull market advances have invariably started from valuations implying prospective 10-year total returns of nearly 20% annually (which is precisely why the secular advances that follow are so durable). The market decline required to build in prospective returns of that magnitude seems too extreme to even contemplate. Indeed, we estimate that the S&P 500 would presently have to decline by nearly 40% simply to reach valuations consistent with prospective 10-year total returns of 10% annually. It’s an open question whether we’ll see that level of prospective return in the next market cycle, but even if we touch that level of prospective returns 5 or 6 years from now, stocks will have gone nowhere in the interim (including dividends). Investors would need to have a terribly short memory in order to rule out that sort of risk. Last week’s valuation chart may be a useful reminder of where we stand relative to history.
On the subject of profit margins, James Montier at GMO published a nice piece last week, using a little-known national income identity (the Kalecki profits equation) to demonstrate that:
Profits = Investment – Household Saving – Government Savings – Foreign Savings + Dividends
Some might object that this is simply an identity (true by definition) and doesn’t imply causality. That’s a reasonable point, but as with all analysis, it’s not enough just to toss out an objection and walk away – you’ve got to go to the data and find out the truth. So let’s do that.
We can actually simplify things a bit to make the point more intuitive. As we’ve shown before, gross private investment has a very strong relationship with the current account deficit (“foreign savings”). Specifically, large increases in gross private investment are almost invariably financed by running a trade deficit in goods and services, and importing foreign savings to make up the difference. Meanwhile, dividends tend to be very smooth, so they don’t introduce a lot of variability to the equation.
What remains then is a fairly simple assertion: the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.
If we go to the data, we see the link between profit margins and deficits in the quarterly figures, but the tightest relationship is actually a causal one – large government deficits (as a percentage of GDP) coupled with weak household savings rates result in temporarily high corporate profit margins, with a lead of about 4-6 quarters.
The conclusion is straightforward. The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely. Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins. With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.
[Geek's Note: If you think in terms of equilibrium in the associated real output (actual goods and services of one sort or another), the Kalecki equation also means that the deficit-financed goods and services are essentially already spoken for, so the resulting corporate profits are not matched by similar increases in real investment. Instead, corporations accumulate claims on the government and households (i.e. they acquire a pile of government and consumer debt obligations). These obligations can only be "spent" in aggregate by the corporate sector on investment goods once households and the government begin to release a "surplus" of output by saving instead of spending beyond their means. Either that, or the trade deficit would explode as corporations accumulated investment goods by transferring their claims on the U.S. government and households to foreigners.]
A few quick economic notes. Real income declined month-over-month in the latest report, which is very much at odds with the job creation figures unless that job creation reflects extraordinarily low-paying jobs. Real disposable income growth has now dropped to just 0.3% year-over-year, which is lower than the rate that is typically observed even in recessions. Real personal consumption growth ticked up slightly from 1.6% to 1.8% year-over-year, remaining in a range that is rarely observed except in association with recession. Given the contraction in real income, we also saw a sharp downturn in the savings rate in the latest report, to the lowest level since just before the last recession. While the slight bump in consumption could help near-term corporate profits, the income dynamics aren’t supportive of a continuation at all.
Finally, we’ve been watching the new unemployment claims data for some time. Almost without fail, when a new number is released, the new claims figure for the previous week is revised upward by about 3000 or so. Last week, we saw an unusual revision in new claims data, not just for the previous week, but in months of prior releases, with upward revisions averaging about 10,000 in the most recent reports (e.g. the Feb 25 figure was revised from 354,000 to 373,000). This reflects an annual update in the seasonal factors used by the Labor Department (which is why the revisions weren’t matched by similar changes in the non-seasonally adjusted data). It’s not clear what this implies for revisions in the monthly employment figures, if anything, but our “unobserved components” models continue to suggest a general trend toward disappointments in economic data, particularly over the next 6-8 weeks. Given that so much investor enthusiasm has focused on the new claims figures, it’s interesting that the large and generally upward revisions in months of prior data seemed to go virtually unnoticed.
As of last week, the Market Climate remained characterized by a hostile syndrome of overvalued, overbought, overbullish, rising-yield conditions. We’ve reviewed a variety of operational definitions of this syndrome in numerous prior weekly comments. Forget about the major declines that typically followed the handful of other instances we’ve observed this syndrome in the past, including the major peaks in 1972, 1987, 2000, and 2007. Even if we look over the past two years – and despite some early signals where market weakness was postponed by extraordinary monetary interventions – we still have not observed these conditions without resulting market declines of more than 15% (one in 2010 and another in 2011) that wiped out all of the gains since the earliest signal occurred, and then some.
Monetary interventions can periodically fuel speculative runs, which defer and spread out the adjustments that result from persistent overvaluation and misallocation of capital. But they can’t get around the inevitability of those adjustments. The only real choice policy makers have is how large a bubble they choose to see collapse. On that front, we’re clearly in better shape than we were at the peaks of 2007, 2000 and 1929, but conditions are generally more hostile than they have been in the vast remainder of market history. This will change. By our analysis, now remains one of the worst times on record to assume that market risk is acceptable.
Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value remains 50% hedged, its most defensive position, and Strategic Total Return continues to carry a duration of just under 3 years in Treasuries, with about 5% of assets allocated across precious metals shares, utilities, and foreign currencies. We don’t view the prospective returns in any asset class as being desirable enough to “lock in” on an investment basis, which means that most financial risks here are essentially speculative, and rely on the emergence of investors willing to accept even lower prospective returns. Again, the one constant in the financial markets is that these conditions will change. Patient opportunism remains essential here.
Tags: 8th March, Andrew Smithers, Assumption, Corporate Profit, Corporate Profits, Correlation, Earnings Growth, Extremes, False Sense Of Security, Fed Model, GDP, Horizons, Hussman Funds, Profit Margins, Ratios, Sense Of Security, Stock Market, Toy Models, Valuation Methods, Wall Street Analysts
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