It is always darkest before the dawn.
The permabulls (who generally missed the 2008-09 Bear Market Great Decession), until recently have called for a "V"-shaped domestic economic recovery and have been targeting about 1300 on the S&P 500 index as their objective. Some strategists, like JPMorgan's well-regarded Tom Lee, remain steadfast in their views and are still holding on to this target despite the ambiguity of the current soft patch that has taken most permabulls by surprise.
By contrast, the permabears (who generally missed the near 60% upside move in stocks from the generational low and the sharp recovery in domestic GDP) have called for a double dip in the U.S. economy and have been targeting about 900 on the S&P. Their mantra consists of "Black Crosses," "Hindenburg Omens" and structural, fundamental and nontraditional headwinds ("It's different this time").
I think both camps are hyperbolic (the bears more than the bulls) and attention-seeking, but their respective views will likely not provide investors with viable or profitable strategies.
The investment and economic "truth" likely lies somewhere in between.
For some time I have suggested that the economic recovery would be uneven and inconsistent. At times it will appear that the economy is headed back into recession; at other times it will appear that the economy is reaccelerating its growth rate.
I see nothing to alter this view.
As I have previously written, we are in this vortex of tax and regulatory traps. The uncertainty of policy has resulted in what can be viewed as a fiscal tightening and a paralysis of corporate indecision. Arguably the continued weak series of economic releases over the past week increases the possibility that, by year-end, we will see a renewed sense of urgency from our politicians for policy relief from the tax and regulatory logjam.
A catalyst to a tipping point of changing fiscal policy could also occur as an outgrowth of a Republican win in November's elections, leading to a decision to continue the Bush tax cuts or even institute a payroll tax cut (or other "outside the box" initiative) in early 2011. (The market, as it usually does, will likely react positively in advance of these possibilities.)
In direct contrast to Wired magazine's Peter Schwartz and Peter Leydens's 1997 "The Long Boom: A History of the Future, 1980-2020" -- "We're facing 25 years of prosperity, freedom and a better environment for the whole world. You got a problem with that?" -- investors see us in a new paradigm of slow or no growth. But just like Schwartz and Leyden's bogus paradigm, which set the stage for the tech bubble and its collapse, the newest paradigm of Roubini-like gloom, "The Short Boom" -- like the "Long Boom" it follows -- seems likely to be also dead on arrival.
An easy Federal Reserve that is content to maintain a zero-interest-rate policy indefinitely, coupled with a cycle low in inventories, residential investment, automobile unit and capital spending sales relative to their long-term relationship to GDP and relative to their longer-term trends, argue strongly against a domestic double dip. Moreover, an expected mean regression of these four series could provide important support for a moderate expansion in GDP growth in the years ahead.
In other words, the current soft patch indicates a moderating expansion but not a double dip.
And history shows that that moderate economic growth typically produces positive investment returns. Since 1950, quarterly real GDP growth rates of 0% to 1% have produced a quarterly return in the S&P 500 of more than 2%. According to Miller Tabak's Dan Greenhaus,
Equity returns needn't be negative in a slow growth environment. ... There's about a coin flip's chance of the S&P 500 being down in any given quarter in which GDP contracts. Viewed another way, 50% of the time the economy contracts in a given quarter, the S&P 500 increases in value and does so by more than 9%.
Stocks Are Extraordinarily Cheap Against Interest Rates
The low level of interest rates remains the single most compelling bullish argument for stocks -- and there are many examples of a disconnect between stocks, interest rates and other metrics/markets of risk.
* For the first time since 1962, the yield on the Dow Jones Industrial Average exceeds that of bond yields.
* Risk premiums (the difference between the earnings yield of the S&P index and the 10-year U.S. note) is at the highest level since the beginning of the modern era's bull market that began in the early 1980s.
* Nearly four-fifths of the companies contained in the S&P 500 index possess earnings yields that are greater than bond yields. And many have (growing) dividend yields that are similar to their own bond yields.
* In a Friday conference call, JPMorgan's Tom Lee observed that the performance between bonds and stocks over the past 10 years has never been as wide in any decade in history. Whenever stocks have a negative 10-year gap in performance relative to fixed income, the average yearly return in the following decade is approximately 13%.
* Stocks are moving contra to the improving risk metrics and risk markets. For example, two-year bank swap spreads are back down to April levels -- when the S&P 500 traded at 1218.
* Stocks have also disconnected from the junk bond markets. The high-yield markets are economically sensitive and are not indicating a broad economic slide. Junk prices are only about 3% off their high and stand at nearly +9% year to date. By contrast, stocks are 14% off their highs and are down by 4% year to date.
Finally, Mike O'Rourke of BTIG had some further solid observations about how undervalued stocks are relative to interest rates last night:
The "BTIG Fed Model" attempts to place a more conservative and defensive twist on the traditional Fed Model. When the levels of risk and fear rise in the financial market, Treasury Bonds represent the safe haven for investors and Equities are a proxy for risk. Thus, Treasuries become expensive relative to Equities, but that heightened level of risk is the obvious reason for that shift.
In order to account for the fear risk, in the BTIG Fed Model, we use the Vix in conjunction with the 10 Year Treasury Yield to raise the threshold with which Equities must compete. During these episodes of heightened fear, the Vix traditionally moved inversely with the 10 year Treasury yield. The Vix rises with the volatility and Treasury yields contract due to a flight to quality. Thus by taking the Vix and dividing by 10 and adding it to the 10 Treasury yield, we derive a larger number representing bonds not only reflecting the expected cash flow, but also adjusting for the heighted level of risk investors perceive in equities. Then comparing this "higher bar" to the S&P 500 earnings yield, one is comparing this relationship on a more conservative basis for equity investors. Additionally, we are using trailing S&P 500 earnings yield, which is also more conservative than using forward estimates.
What is extremely noteworthy about this metric in the current environment is that the level of equity undervaluation relative to Treasuries today using this model is equivalent to the extreme levels registered in early March of last year.
The improvements for equities are on all fronts. As we noted last week, Treasury yields today are lower than they were at the equity market bottom. The Vix is at one half its level of March 2009 (simultaneously, it is not low either) and very importantly, corporate earnings have mustered an incredible rebound. We are asserting that on a risk adjusted basis, the environment for equities versus bonds today is the equivalent to that of early March 2009.
The improvement in the standing of equities in this relationship will likely come from reversions on both sides -- equities rallying and bonds selling off. While there are no guarantees that equities will not get cheaper, this certainly indicates the odds of success are much greater for investors who are on the bid side of the equity market.
Valuations Are Compelling
At under 12x 2010 estimates, equities seem inexpensive to a multi-decade average of over 15x and at 17x when inflation is contained and interest rates are low.
Since 1962 the yield on the 10-year U.S. note has averaged about 365 basis points above the quarterly pace of real GDP growth. With the current 10-year yield of 2.58%, the fixed income market is discounting negative real growth in the domestic economy.
As Omega Advisors' Lee Cooperman mentioned over the weekend, industrial companies are taking notice of the developing values -- it is unlikely that BHP and INTC would propose spending $30 billion and $9 billion, respectively, for the acquisition of POT and MFE if they felt an economic apocalypse was on the horizon.
Economic/Stock Market Expectations Are Low
There is not a market participant extant who doesn't recognize that the slope of the recovery in the domestic economy will be "different this time," and that the ramifications of the administration's populist policy, the growing perception of a structural rise in U.S. unemployment, consumer deleveraging, concerns of deflation, the emergence of nontraditional (and intermediate-term) headwinds (e.g., fiscal imbalances, higher marginal tax rates, costly regulation, etc.) all will serve as a brake to domestic growth.
And what about the common view that the consumer is spent-up, not pent-up? The bearish view that the consumer is the Achilles' heel to growth might be worthy of challenge.
As Morgan Stanley noted late last week:
American consumers are deleveraging their balance sheets and rebuilding savings faster than expected. While debt/income is elevated two key metrics indicate that the deleveraging timetable is nearly a year ahead of schedule. Looking forward, the plunge in mortgage rates will likely push debt service still lower. And the headwind to consumer spending from deleveraging will be a smaller risk to the outlook, as consumers now can spend more of their income.
We believe that 11-12% is a sustainable debt-service ratio, consistent with debt/income of 80-100%. The first of those goals likely is attainable by late this year, accompanied by real annualized spending growth of 2-2.5%, a personal saving rate remaining in a 5-6.5% range through 2011, and a 2009-11 contraction in consumer debt of about 8%. ... Lower debt service frees up discretionary spending power and makes consumers more creditworthy. Once achieved, a higher savings rate enables consumers to maintain spending, continue to pay down debt and accumulate wealth the old-fashioned way.
Sentiment Weak ... and Weakening
Much like 17 months ago, we appear to be rapidly approaching a negative extreme in market and economic sentiment.
The hedge fund industry has derisked. Net long equity positions remain low by historic standards and, increasingly, hedge hoggers (like Stan Druckenmiller) are leaving the business.
To some degree, Stan's decision reflects how difficult it is to deliver superior investment returns in a world driven by the uncertainty of policy and economic/investment outcomes superimposed by the destabilizing effect of an algorithm-based world of short-term momentum strategies and, perhaps even more importantly, short-term-oriented investors. His decision reflects an investment world that has grown increasingly less predictable, and the ability to deliver superior investment returns has been challenged, in part by some of the factors mentioned above. We're in an environment in which portfolio managers and investors are dually frustrated. To many, it is getting to the point where "it's no fun anymore."
Importantly, Stanley's exit is reminiscent of when value was out of favor and glittering hedge fund manager Julian Robertson quit in the early 2000s, so I suppose you can say that history rhymes! But remember, almost as soon as the ink dried and Julian closed shop, his beloved "value stocks" came back in vogue.
Such a shift could happen again as a dysfunctional market moves back into a biased-to-the-upside trend -- just at a time when some throw their hands up in the air in despair!
And, as vividly expressed in Sunday's New York Times Business section ("In Striking Shift, Small Investors Flee Stock Market") retail investors have fled domestic equity funds in favor of yields in the bond market. (Over the last year, there has been a record flow into bond funds compared to equity funds.)
With the two dominant investor groups -- hedge funds and retail investors -- derisking, who is left to sell?
The U.S. stock market has already discounted a recession/double dip. And the notion of secular headwinds has been recently adopted by the consensus and has contributed to a weak equity market.
Domestic economic and stock market expectations are low.
While a number of risk metrics and risk markets have improved, equities still lie near the bottom of a projected trading range.
Stocks are especially attractive relative to interest rates, and an extended period of underperformance against fixed income has soured both hedge funds and retail investors toward equities.
It is time to fade the growing negative consensus and adopt a variant view by becoming more constructive on stocks.