Tuesday, September 27, 2011

Monday Thoughts

"Imagine there's no Heaven
It's easy if you try
No hell below us
Above us only sky
Imagine all the people
Living for today

Imagine there's no countries
It isn't hard to do
Nothing to kill or die for
And no religion too
Imagine all the people
Living life in peace."

- John Lennon

Today was a very good example of what happens when many classes of investors (retail, institutional and hedge fund) are all "off sides."

Imagine if I am correct that worldwide economic growth will moderate, but not move into recession territory and that corporate profits will maintain their integrity and not fall out of bed either.

Consider that retail investors have pulled $400 billion plus from domestic equity funds since 2007 and have added $800 billion plus in fixed income funds, for a swing of more than $1.2 trillion away from stocks. And that more money has been redeemed from equity funds in the last three months that at any three-month period since late 2008.

Imagine how powerful is the potential tide of a massive asset reallocation out of fixed income (which is earning very little current income) and equities (which have the widest spread between their earnings yield and risk-free rates of return).


New-home sales of 295,000 were in line with expectations, coming in basically in line with the 270,000 to 325,000 range over the last year. This series has been flat for a year, but it is important to recognize that existing-home sales have been improving (up 15%), as have prices increased over the last four months. The latter, existing-home sales, are benefiting from active sales of lower-priced foreclosed properties. Months of sales of unsold new homes stands at 6.6, still above the longer-term average of around 7.5 months. In summary, residential real estate activity has stabilized at low levels, and the impact on 2012 GDP will be slight as it is now such a low percentage contribution.

The broad-based gauge of current economic activity, the Chicago Fed National Activity Index, uses 85 different metrics to measure economic growth, so it is a good indicator. August came in at -0.43 (consensus was -0.37), and July was 0.02. A recession reading for this measure is between -2.0 and -5.5, so the August release is more indicative of a moderating domestic recovery that one that is entering recession.

Mr. Market usually inflicts the greatest hurt on the most investors. Who would have thought in March 2000 that the S&P 500 (at around 1535) would make no progress over the next seven and a half years and that the November 2007 high of about 1555 would drop all the way down to 666 in March 2009 (and then nearly double in the next two years!)?

To me, stocks today are increasingly cheap relative to fixed income and relative to private market values. The market has finally begun to discount the uneven and inconsistent economic climate that I (and others) have anticipated over the last year and a half.

We should never be handcuffed by statistics, but it is interesting to note that over the last 50 years, the S&P 500 has averaged 15x while the average yield on the U.S. Treasury bond was at 6.70%. Now the 10-year U.S. note is at 1.80%, and the market’s P/E is 12x.

Or, consider that at the height of the financial crisis in late 2008, the yield on the Bloomberg high-yield index was over 25% -- the S&P 500 sold at almost 14x then. Today the yield on junk bonds is 8.25%, and the S&P 500 sells at 12x.

To be sure, I fully recognize that the U.S. economy has matured over the last 50 years and is now plagued with structural challenges that are as unique in context as they are difficult to counteract and that our financial hegemony has been challenged and, in recent years, has been ceded to China. But these factors, though limiting the market's upside, are now universally recognized and might possibly have begun to be discounted by not only the recent market weakness but by the extended decade-long drop that dates to the S&P 500's high of 1525 all the way back in March 2000!