Stocks in Extremistan As Recession Forecasts Continue

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:

Insider Sentiment
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.

 

 

 

 

 

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16 comments to Stocks in Extremistan As Recession Forecasts Continue

  • Johnny

    Very informative and as usual well written. I am currently buying lots of silver and holding both SDS, stocks and 20 C options out until 2014.

  • [...] They Ring a Tinker Bell At the Top? Read more: http://dailycapitalist.com/2012/03/18/do-they-ring-a-tinker-bell-at-the-top/ Share this:TwitterFacebookLike this:LikeBe the first to like this post. [...]

  • innertrader

    Good information and very well written!
    Thanks!

  • No Country For Constitutional Men

    Well done and great information. I will be passing this on to others, as this info deserves to be seen by as many as possible before they pull the rug out from what’s left of the retail investor. The 10 Year is already flashing red, as it was up 13% in price last week at a time when the FED is defending it through Operation TWIST.

  • innertrader

    One observation I want to mention, that I think is important when looking at the presented charts. The change during the Reagan administration, in the investment tax laws creating all the individual retirement accounts that started putting money into the stock market in the late 80s and the tech boom coming at the same time is an event that will never be repeated. That size of increase of funds invested into the stock market, can only happen once! I think this is important in considering a comparison.

  • No Country For Constitutional Men

    This chart from Market Ticker speaks thousands of words to anyone paying attention. It goes back to 1980 when the various bubbles had their origination. You will notice that the degree of the slope more than doubles while the timeframe for each period is cut by more than half. You can’t outrun exponential math or maximum potential although the pump monkeys would love to sell you their shares before the implosion.

    http://market-ticker.denninger.net/akcs-www?get_gallerynr=2772

  • Squire

    When the S&P finally drops from 1500 to 1450, those negative on the stock market will finally pat themselves on the back.

  • All comments appreciated.

    Squire: speaking not for all “those negative on the stock market” but rather just for myself: no, a 3% correction from peak to trough is meaningless except to traders who are virtual day traders. Last summer, every day seemed to see at least a 1% intraday swing. Meanwhile e.g. on Jan 1 1999, the NAZ was fated to double that year then go up more thru March 10, 2010. But it was then to collapse to little more than half the Jan. 1 1999 level soon. Then more than double, then halve again. So who was right on Jan. 1 1999- bulls, bears or both? All depends on your investing/trading style.

    You’re of course free to care about short-term price swings such as you describe. But that topic has nothing to do with my laying out a scenario in which I kept talking about the months ahead, multi-year time frames etc.

    Meanwhile the VXO has just hit an intraday 5+ year high; back to pre-GFC Rosie Scenario territory.

  • Squire

    This fine article is well constructed with lots of good information and appreciated anecdotes and I now have re-read it two times. I gained some insights. Most, the idea that funds are not highly valuing the 12x PE stocks is telling to me. Thank you DoctoRx.

    In December 1999 when I was a trustee for a pension plan I started persuading the board to go to cash which they did finally achieve by March 2000 (making me a hero). You see, on the same day that my trading partner attended a day trading seminar that was attended by retired people, I got my haircut where in a young high tech employee in the chair told my barber that the really neat thing was that you don’t actually have to make any money. We knew it was over. In early 2008 my CEO, president, and I, the CFO, desperately started hawking our company which finally sold in July 2008. Just in time. These are my credentials.

    It is all about psychology. I don’t think long term any longer. I believe FED action, needed reform inaction, and a pathetic public will prevent the economy from operating, let alone flourishing, without increasing debt. And, a contraction can occur soon. But I believe the market will climb unless there is a shock as there are no sellers and it will take many more people and a much higher market before even serious profit taking will take place. Capitulation to the stock market will proceed, in my opinion. The Russell 2000 broke upwards today. Yet my counteractant indicator is reading extreme over-bought. Hopefully the market pulls back some for a better buying opportunity.

  • No Country For Constitutional Men

    Squire, would the 12X PE stocks you mention in your post be according to historical earnings or forward earnings to derive the PE? I ask because I’ve seen the carnage done to investors by depending on forward earnings in their decision to buy a stock, so which is it?

  • DoctoRx

    BTW Correction, of course the VXO hit a 5+ year low today (5 year high in complacency per that index)…

    And FWIW, re overbought states, Louise Yamada likes persistent overbought states as signs of strong buying interest. Don’t know your system, Squire, but as a veteran of the momo markets of the ’90s, I have great respect for steamroller markets. Think silver 2010-11 etc. Good luck w the pullback hopes and successful buying of the dip…

  • No Country For Constitutional Men

    DoctoRX, volume is terrible YTD and price is being held up by HFTs/Brokers scalping each other for a fraction of a cent using nano seconds as their time held. 16 weeks of outflows of equity funds while the markets soar say Yamada is full of Shite’. Louise is talking her book while unloading stocks to a greater fool. Here’s a clue. They are unloading their stocks while frontrunning the next QE in Treasury Paper. Why do you think the 10 Yr. is up 15+% in yield in less than 10 trading days while Operation TWIST is still in place?

  • No Country For Constitutional Men

    Here’s another lie from The Bernack who said the FED wasn’t bailing out the ECB.
    Fool me once shame on you. Fool me multiple times and I’m a foiken idiot.

    US Taxpayers Commence Bailing Out ECB, With Greece As Intermediary

    http://www.zerohedge.com/news/us-taxpayers-commence-bailing-out-ecb-greece-intermediary

  • No Country For Constitutional Men

    The last point I would like to make is that the FED is being beaten like a dirty rug, as it is the buyer of last resort for Treasury paper above and beyond TWIST. As an example using price, the FED must buy (stand on the bid of) the 10 YR. when sellers exceed buyers (rising yields) which it has been since the Primary Dealers are loaded to the gills at this point buying all of last years paper in two months. Even with this going on, the FED sees that the 10 YR. is up 15+% in yield within the last 10 trading days while Operation TWIST continues.

    This is one of two things. The FED preparing for another round of QE giving the Primary Dealers the chance to front run the next round of QE, or the FED has lost control of the yield curve. I vote for number one, but number two will happen at some point which may include the here and now.

  • No Country For Constitutional Men

    Squire, I will take the non-reply as an answer of “forward earning” which can be blown sky high out of the water by any numbers of scenarios. Go study Amazon in the 1998 to 2000 period for your answer on forward earnings.

  • “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.” — I think this is the appropriate characterization of current valuations. Stocks went from fairly priced at around S&P 1150 to being on the pricey side at 1400.

    But the analogies to 2007 and especially 1999 are way out of place. Large caps are 30-60% below 1999 levels on P/B, P/E, P/S, P/E10 (CAPE), DivYld, Buybacks, you-name-it basis. They’re also below 2007 levels on the same measures, though obviously not by 30-60%. At the same time bonds went from being a screaming buy in 1999 to good deal to 2007 to clearly expensive now. Same for gold. You have to allocate your assets to something or other. If you sit in cash and hope to time the next big crash you end up as Hussman has for the last 3 years.

    Fact is everything is on the pricey side (possibly excluding US real estate), so it’s definitely time to lower expectations for the future. But there’s no case to abandon stocks (or bonds for that matter). Valuations are nowhere close to ridiculous levels and, more importantly, there are no appealing alternatives. Cash is losing 2+% to inflation every year. I wouldn’t touch gold at today’s prices (it scares me more than either stocks or bonds). And landlording is a job, not an investment. So we’re back to stocks and bonds. Yes, returns will be underwhelming at best but still better than nothing.

    And about Hussman and Grantham… They are no doubt smart guys but both are on record in late 2008 saying that 1000-1100 level on S&P500 was fair at the time. It’s pretty clear to me that both of them got badly spooked by continuation of the slide into 2009 to way below those “fair value” levels. As the response they both adopted much more bearish tone into 2009 with both saying fair S&P 500 value is in 900 now (how exactly does that square with their call for 1000-1100 fair value in 2008?) Grantham’s funds at least have to be fully invested so they performed OK, but Hussman’s Strategic Growth fully reflected his newfound paranoia and had worst 3 years of any asset you can imagine. Basically both guys let their emotions get the better of them, in Grantham’s case in his tone only and in Hussman’s case both in tone and actual performance. Which is too bad because both made the correct fundamental calls before being spooked.