This is a long post about stocks and the economy. I hope you find it worth the effort to read it.
If there’s any doubt about the strength of economic expansions, on trend, in the United States, in the past half-century, the linked 52-year chart from the Philly Fed may help settle the issue: LINK. On trend, every economic recovery since the official end of a recession appears weaker than its preceding recovery. Yet we are told that stocks are for the long run, that they can be assumed to return about 9% per year if one just sticks with them. But we are also told that inflation is going to be contained around 2-3% per year. What’s wrong here?
Maybe it’s the assumption about stock returns.
Here’s a graph based on over a century of stock market/economic data from Smithers & Co. based on stock prices and data from three months ago:
I have updated the data, which reflects much lower stock prices, and found current stock prices by the Smithers criteria to be about 70% above current fair value at an S&P 500 value of 1400.
This would put today’s stock market at an all-time record high valuation except for the 1999-2000 period and perhaps the very tippy-top in 1929. As Smithers explains, q is a measure of replacement value of the market, and CAPE is Robert Shiller’s “cyclically-adjusted price-earnings ratio”. Thus q and CAPE measure, respectively, underlying asset value and boom-bust smoothed earnings power. Based on both the parameters, “the market” is near its all-time highest valuation, at least going back to 1900.
The mega-fund manager Jeremy Grantham (GMO, which manages many billions of bucks), opines similar things as Smithers from the end of February; click HERE for data, and note how wide his one standard deviation ranges are, so that all stocks by his projections could, if he is at all correct, easily give negative total returns annually for the specified time period of 7 years.
Grantham’s estimate is that U.S. small-cap stocks are worse investments than Treasury bonds, and that the U.S. stock market as a whole is roughly as good or bad an investment as some mix of Treasury and tax-free municipal bonds, though riskier. He does like “high quality” stocks– a differentiation with which I concur, though he notes that these are quite richly valued by historical standards, and as stated are overpriced by their own historical record and have a very large one standard deviation component built into their estimates and thus also could, he estimates, easily provide zero or negative annual returns over seven years. And I do mean zero nominal returns, even though estimates “real” returns.
Both Smithers and Grantham have very good long-term records. Smithers bravely published a book in 2000 calling the stock market the worst bubble in history. By the same calculations he used then, he would, I think, say that we are now close to that peak.
Valuation by itself does not kill bull markets. It is the combination of economic slowdowns, especially outright recessions, that damage/kill the beast. Is it “here we go again” on the economy?
Could be, at least per ECRI and John Hussman.
ECRI has just reiterated its recession call. Recent data has not swayed it. Its public argument involves further slowing of year-on-year growth in two indicators:
Should you want to look at the raw data, here is a link to the spreadsheets that ECRI provides; click on “XLS” to open the one(s) you wish to examine. If you read the linked press release from ECRI, which does not forecast market action, you will see that it points to post-financial crisis issues with winter-time seasonal adjustments to economic data as part of the reason its recession call is so variant from that of the mainstream.
The economist-money manager John Hussman has similar comments as Smithers and Grantham on valuation and similar comments as ECRI on economic prospects. Amongst many other things in his latest article and that of the week before, he writes (based on the lower stock prices as of Friday, March 11, not the yet higher prices as of the date of my post):
Investors Intelligence notes that corporate insiders are now selling shares at levels associated with “near panic action.” Since corporate insiders typically receive stock as part of their compensation, it is normal for insiders to sell about 2 shares on the open market for every share they purchase outright. Recently, however, insider sales have been running at a pace of more than 8-to-1. The dollar amounts are even more lopsided, as Trim Tabs reports a recent pace of $13 of insider sales for every $1 of purchases. Indeed, some of the weekly spikes have been to levels that are associated almost exclusively with intermediate market peaks, the most recent being the run-up to the 2007 market peak, the early 2010 peak, and the 2011 peak, all of which resulted in significant intermediate corrections or worse…
On an objective basis, we identify present conditions among the lowest 1.5% of historical periods in terms of overall return/risk profile.
Are the observable economic data really consistent with an oncoming recession? After all, ECRI’s Weekly Leading Index (WLI) year-on-year data is where it was at the onset of other recessions.
Indeed,there may have been overproduction relative to buying power already based on data that came out after both the ECRI press release and the Hussman article.
The Fed reported at week’s end that January industrial production was up 0.4% from December, but (preliminary) February’s was flat. However, the BLS reported Friday that real personal income has been deteriorating since peaking in October, accelerating, so it reports, to a massive 0.3% drop in February alone. That is, personal income has been deteriorating ever since October 2010, not 2011.
So what does all this mean? Did the build-up in industrial production in December and January represent malinvestment that will have to be dumped into a weakening market for final sales? Could be, so far as I see.
When I talk to real people, I find things are iffy at best. I have seen several booms in my life. What’s going on today is Not.One.Yet.
The largest hospital system in Miami is eliminating about 1100 jobs; and, a recently-graduated R.N. cannot find work now– a thoroughly unprecedented situation. The sister public hospital chain in the county just north of Miami-Dade County is also shrinking. Even doctors are scrambling to make house/hotel calls to bring in extra revenue. A friend co-opened a retail store in a nearby prosperous beach-area community, which is shutting down after one year. She reports that most of the retailers on the main shopping street are finding times to be tough. She “cannot sell” her house in an affluent area of Long Island (meaning both that she won’t lower her asking price yet again to meet the market price, but also that there is no strength in the real estate market there, inflating homebuilding stocks notwithstanding). Her boyfriend, a serial entrepreneur, is looking for a business opportunity, and has yet to find one. A California-based friend in the aerospace business reported this week that a tsunami of layoffs is coming from the military-industrial complex. He has made so much money from a certain well-known tech stock over the years that he plans to retire soon and move to a state with a much lower tax burden. Indeed, California appears to have taken an economic step backward in February. But not all is gloomy. A close relative in the hi-tech field has obtained a much better job at much higher pay. And sales are booming, and employment is increasing, at that hotbed of innovation– Mickey D’s (McDonald’s’ “handle” on the Street): LOL.
So I have begun very recently to feel the disconnect that I started to feel as 2007 moved along, and stock prices moved up while the economic and financial worlds that I could see did not justify the optimism.
The past decade except for the depths of the financial crisis, the regional Fed and the ISM surveys have almost always have shown much higher future expectations than the assessment of current conditions, and that is the case today. And then the much brighter tomorrow never comes, even if business is decent– but the expected (not just hoped-for) boom never seems to come. This persistent overoptimism these businesspeople express is the triumph of hope over experience, fueled by the media, and thus is, I think, therefore an important negative sign as that optimism becomes embedded in inventory levels and in securities prices. Contrast that to the post-WW II era, when “everyone knew” that the economy could not absorb millions of returning servicemen, that the 1945 and then the 1948 recessions were the precursors back to major deflationary depressions, and stocks and bonds were priced accordingly. Rational expectations were dead wrong then. Will expectations be right today, rational or not?
Today, “everyone knows” that stocks are the right intermediate-to-long term way to allocate capital, and similarly they/we “know” that since interest rates and probably inflation have nowhere to go but up, Treasurys all along the yield spectrum are poor if not disastrous long-term investments.
But this completely ignores the action of both stocks and bonds in the obvious two major country credit collapses: firstly, the U.S. post-Depression experience that stocks were poor investments when q and CAPE (Smithers, chart above) were below but close to current high-risk levels, and secondly the post-1989 Japanese experience- 23 years and counting. Is this time really different? Well, maybe past is not prologue. But in order to risk not other people’s money but my own and my family’s, how can I be sure, even in a world that’s constantly changing?
I am seeing the same sudden optimism from people who are financially secure. An older friend who spends all his time on his charitable pursuits called me out of the blue last July, when stocks were plunging. He was concerned that the 5% of his assets that were in (blue chip) stocks were at risk, and he wanted my thoughts. I was able, with his broker, to talk him out of hedging in the futures market against large declines in the stock market. Talk about unwarranted panic, and from a man who is leaving his fortune to charity. By late fall and this winter, he was much more interested in owning the stock market. When I mentioned various recession calls to him, he was dismissive. No recession loomed, he proclaimed. Similarly, a different friend, a lawyer with whom I grew up and an active investor, asked me in December why I didn’t own many stocks. Since he is a Krugman follower, I simply mentioned that the San Francisco Fed’s model projected a 50% change of recession in the next two quarters. He was also dismissive. No chance.
What “everyone knows” may come to be so, but is it not already largely, if not completely, “priced in”?
It thus appears that the relentless cheer leading of the media has convinced many people that the enlightened Keynesian policies of the past few years have corrected the failures of the G.W. Bush administration, and happy days are here again. However I suspect instead that the glamour girl Rosie Scenario has returned to town and that she has investors bewitched, bothered and bedazzled. As with the audience’s prayers saving Tinker Bell from the poison she drank in Peter Pan, the fervent wishing of the economy back to health by inflating stock and bond prices has done the trick, and full health has been restored- so it is felt.
Yet there is, in the words of a Keynesian-oriented former politician turned capitalist, An Inconvenient Truth: A large amount of good news that is embedded in stock valuations has yet to happen. And since life is not Peter Pan, and wishing can’t make it so, all that embedded good news on dividends, earnings, asset values and competing interest rates may just not come to pass. Or it may come to pass, but after– who knows– an inconvenient recession.
Not wishing or hoping, just saying …
If Grantham and Hussman, who as stock-oriented asset managers have every financial incentive to argue that stocks are undervalued, are correct along with Smithers, then stocks are overpriced relative to their own historic risk and volatility and much lower stock prices may loom. In that case, merely decent news on the economy will allow stocks at least to hit an “air pocket” and should a recession strike any time within the next five years, the accumulated dividend payouts would likely not compensate for the typical 30% drop in stock prices associated with said recession (assuming the Dow does not exceed 19,000 by then), and if a recession strikes within the next two years, that result can be considered highly likely. Given that recessions have struck the U.S. more often than every six years since the Great Depression, and much more often before it, and given that the last one began in late 2007, it is reasonable to fear that one way or another, another one will begin within two years.
Supposedly we have nothing to fear but fear itself. Wish hard for Tinker Bell: buy stocks. Such as the institutional fave AMZN at 130 estimated (and dropping) 2012 earnings. Because it will reach a permanent plateau of prosperity. Somehow. Someday. Promise? NO. From ETrade re AMZN:
RUBINSTEIN JONATHAN J became the first insider to ever buy AMZN stock when they purchased 165 shares on November 4, 2011
Amazon.com was one of the hottest stocks in the ’90s and thus one of the crashiest in the ’00s, but no insider EVER bought the (blankety-blank) dip. Finally one director spent the cost of a Toyota on the stock. First. Time. Ever.
Fine company that it may be, AMZN has a lot of winning the future to do before it can justify its $84 B market cap. Of course, it can’t be bothered actually generating much free cash to compensate the outsiders for holding the stock the insiders keep dumping on the outsiders– that would be so 1950s. We’re back to eyeballs plus Paypals. Not to dump on Amazon, for all I know it will outperform every asset I own. Just to point out that this well-known company is owned by the biggest funds, and thus it shows how much they are willing to pay for perceived true growth; and thus it shows how little growth prospects they see in the stuff they value at 12x 2012 estimates (hint: almost none). And unless you know a company or industry very well, these guys know everything you think you know and much (usually much, much, much) more.
There can, I believe, only be one “best” explanation for today’s valuations: Investors, or shall I say “investors” (take your pick), have looked at current ultra-low interest rates and reacted inappropriately. They have forgotten that ultra-low interest rates can sustainably exist only in a situation such as post-1932 American or post-bubble/crash Japan, where malinvestments don’t get liquidated fast. Thus, capital gets “neutron bombed”: it exists in nominal form but with nowhere to go. So the real economy stagnates while the valuation formulae that money managers use to value stocks by comparing them with short and long-term interest rates first leads to spectacular rallies but then fails because said formulae fail to take into account that these low rates are not simply because one central bank creates some new money to buy bonds, which of course each country’s central bank does. These low rates exist not just due to central governmental policy, but also exist because smart money is not bidding aggressively for real assets which have mostly been created in excess due to the various booms of not just one economic cycle but the cumulative economic cycles each of which was forbidden by the authorities to undergo a healthy cleansing of malinvestments.
Putting matters in an American perspective again, stocks did not bottom until dividend yields got to high single digits while interest rates stayed at today’s low levels. Meanwhile, fast-forwarding to 2012, the markets have skipped the 15+ year mostly-very depressed period the first chart above (Smithers) demonstrates and have gotten back to partying, incredibly returning to 1999 and 2007 levels of overvaluation. Yet as I described above, even a minimal pullback in U.S. defense spending is at least per one source leading to important layoffs in a high-paying industry. What happens in a new recession? Why will not stocks finally revert back to their relative valuations of, say, 1988? Or 1978?
Thus I believe that the “SALE” sign in the stock market has been taken down and it is back to full price weekdays, not Sale Sunday on the Street.
Bonds and cash are obviously not cheap either. So, as it goes in the field of conventional investments, pick your poison. We may muddle through-or better. I am not Poe’s raven, preaching doom, and I profess no certainty of any outcome. Some securities and asset classes will appreciate no matter what happens, and nothing said herein is very helpful on timing any market.
Whatever investment poison you, the small investor, may choose to drink, the current investment game is not being played in a fairy tale, you are not Tinker Bell, and there will be no prayers from The Powers That Be for you should your capital look to have been, as time goes by, at least temporarily malinvested.