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From Economy to Markets: More Bubble Busting Due ? (Updates !)

I had occasion to be chatting to my Schwab guy this last week and asked him what he was seeing, or better, what Schwab was seeing. The answer was that after getting hammered they're seeing a bunch of business flow back in. And their CIO just "called" a bottom sort of - in their typically cautious way at least and suggested it's time to start dollar-averaging back into the market. Now Schwab is a class act who runs a good show and has displayed a lot more integrity than most over the last decade. Nonetheless, despite my guy's caution hemming and hawing, it strikes me they're getting suckered along with the rest. In fact what we think is going on is that a lot of money managers are jumping back in because everybody's doing it and now retail investors are getting sucked in as well. The problem, is you buy into any of the last several posts on the real state of the economy, is that this ain't grounded in the data.

Our bottomline - now doesn't look like the time to be getting back in despite what the gurus and charts might be telling us. Let's explore why we're getting nervous and would suggest that, at minimum, now would be a very good time to be on the sidelines. Take a look at this YtD chart of the SP500. Right now we're still roaring up the up-channel, but as you may recall that's largely been on the back of all the "good" news on the banks from the Pandit Put to TimmyG's Plan to Thursday's Stress Test - which was actually a lot worse news than anybody let on. Not to mention our points in the prior post on the other tsunamis still to come.

Market Dynamics: Jan08-May09

Let's pop up a level and take a look at what's been going on in the bigger picture. In this weekly SPX chart from Jan08 to now the really important indicator is the moving average which captures the dynamics. From Jan thru Sep08 which had a nice, tidy and optimistic bear market until the fecal matter hit the impeller with Lehman's collapse and the breakdown of the credit markets (btw - TimmyG was on Rose Thur. night and admitted that they all thought Western Civilization was ending, at least in so many words). Let's call that the meteor strike of the disequilibrium event. Or the dinosaur extinction event. When you pop up to this timeframe you can see where the new equilibrium  that appeared at the beginning of this year disapeared in March and what we've been doing is repairing the damages of that panic attack. Other than this last week or so's surge all we've really done is get back inside the trading range that we were in from Oct/Nov to Feb. When you look at the Slow Stochastic you can see that it's still roaring ahead. So there's still a lot of momentum in the market. In fact a huge amount, judging from the massive runup in the SlowSto. Until it and the MACD turn over you can still try playing for the upturn and then we'll see. But depending on whether you're an investor, a trend trader or a scalper you'll want to think hard about how to play all this. Again the steer clear advice seems well grounded to us.

Linking Markets and Economy

Let's really pop up a level and re-visit an old and familiar meme here. That, to wit, the economy drives profits which drive earnings which drive the markets. We'll try and make those points off this busy little composite chart - sorry for the noisy top part. We're trying to say too many things at once. In the top the faint lines are the YoY% changes of GDP, Profits and the SP500 on an annual basis. The only really important point for now to take away is that the relationship appears to hold. The heavy lines are non-linear trends which make it clearer. Notice how closely Profits follow GDP and, in turn, that the SP500 follows both but tends to amplify the cyclic patterns. Until recently when it ran ahead. The bottom sub-chart is the cumulative change in all three from 1950 to now which, IOHO, really makes the key relationships clear. Notice that they basically cohered up until 1995 when the "this time it's different" delusion took over the markets. Interestingly about the time that bubble was being drained it re-inflated in this Housing ATM driven fantasy over the last several years. Even more fascinatingly, at least to us, Profits followed GDP until 2004 without exception or major variance. Think about that - FOR FIFTY-FOUR YEARS PROFITS MARCHED WITH GDP ! Then, in the weakest "recovery" in post-war experience they started their own bubble and carried the market back with them. Now we know that a lot of those so-called profits were a) delusions from Wall St. idiocies and b) in the real economy the lack of hiring and capital expenditures of the folks who actually ran real companies. Judging by this chart we've got a lot of bubble deflating to go. Unless of course you'd care to argue that the fifty-four years of experience, of the forty-five up until 1995, were the screwy anomaly and the last decade the real deal ?

Analysts vs Realities

Let's borrow an interesting little chart from John Mauldin and take a look at the analysts collective guesstimates on where away for earnings. It shows the estimates for 2008 and 2009. For 2008 they started at $92 and dropped to an abysmal $15. the really interesting thing is that they "only" dropped to $60 by Sept. when the floor caved in with the market collapse and all of a sudden they flopped over the cliff. We'd say went diving but that implies deliberation and skill, at least according to the guys in Acapulco. Then the estimates for 2009 started at $81 and went to $29 and again display an inverse J-curve with a lot of that re-thinking happening at the end. So much for visbility. Now if you think $28 or so is reasonable and you also accept a "conservative" PE Ratio for a seriously recessionary environment is 10-12 then we're in a pretty funny space for the SP outlook. 28 X 12 = 336 after all so let's say 400. Or better if you think Shiller's long-term estimate of 15 is accurate we get a little better. But at the end of the day it comes down to what earnings are likely and what they'll be worth. If we get an economy that may, but is unlikely, to start growing at the end of this year but stays below potential for a long time PEs certainly won't be coming back above 15 for a long time. Or at least they shouldn't.

Graham-Dodd Valuation and the Outlook

We've pounded away at the G-D formula a bunch of times as well as looked at other alternative approaches so we'll content ourselves with simply pointing to this chart which shows the relationships graphically so you can read them off from either the tables or the graph. Now if we're anticipating high-grade bond yields of, say, 6% for a long time (out investment horizon whatever that might be) and 6% growth in earnings (which on the evidence we've been presenting on the economic long-term outlook is wildly optimistic) a PE of 15 is perfectly justifiable. 6% interest rates seems reasonable to start with though if you're in the hyper-inflation camp you'll want to to you value analyis with something considerably higher of course. But 6% earnings growth would require major continued cost cutting, because it's sure not going to come from organic growth. Or, admittedly, re-leveraging the balance sheet (ahem). But let's say on the basis of all the long-term economic outlooks that 2-4% is more conservative, grounded in facts and analysis and therefore more defensible. That leaves us with PEs in the 9-12 range. Looks like we've come full-circle. Bottomline here is that a 10 PE and $20-40 earnings looks pretty defensible which puts the floor on the SP500 back at 400. Which guess what...would take out all that remaining residual market bubble over long-term growth. You have to wonder if coming to the same conclusions form five to six ways doesn't tell you something, right ?

In any case if you want to keep on readng there's a bunch of interesting columns and stories with a bunch more foor for thought, tools and suggestions that we think is worth your while in the readings after the break. Click on thru by all means.

UPDATES:

It's always gratifying when after you throw something out in the blogoether that a slew of stuff comes rolling across the transom confirming your arguments. Now either a bunch of us are smoking the same stuff and not seeing the immaculate recovery or the punditocracy is self-deluding again (conjur up images of mental masturbation to make it graphically clear). There was just a bunch of stuff over the weekend and so far today that you ought to go read that reiterates a bunch of our themes about 1) mis-reading the data, 2) a prolonged and painful recovery with low job creation, 3) continued business performance pressures and 4) an over-valued market that's a sucker's rally in drag. Take a look and if something catches your eye go read it (the Jeremy Grantham newsletter is critical reading IOHO).

Economic News Updates:

Market News Updates

Market Situation and Analysis

Stop Thinking the 30% Stock Rally Means the Bear Market Is Over Now that stocks have rallied nearly 30% off their low, pundits agree: It's a new bull market.  So be very afraid. Market punditry is a lagging indicator, not a leading one.  Pundits are excellent at describing what has happened, not what is going to happen. But doesn't the 30% rally off the bottom obviously mean that the bears are fools, that it's finally safe to get back in the water?  No.  It doesn't obviously mean anything. Take a look at the charts below, from Doug Short.  (Check out the interactive version here >)First, the "mega-bear quartet"--an overlay chart of the bears that began with the DOW in 1929, the NIKKEI in 1989, the NASDAQ in 2000, and the S&P in 2007.  The last one, the current bear, is the blue line. The horizontal axis is time from the peak, measured in years. If you're feeling confident that the 30% rally means that happy days are here again, take a look at the humongous rallies in the NIKKEI (red) and NASDAQ (green) that happened at this point in the process.  Then look at what happened afterward:

Stocks rising on a raft of regrets? On a frigid Saturday afternoon in early March, I stood on the sidelines of a youth soccer game with a friend who was shivering for reasons that had little to do with the weather. Stocks had just concluded another brutal week, closing down 56% over the past 17 months, and she could not get the market off her mind. A widow who depends on her investments to pay necessities such as the mortgage and health insurance, she was being forced to contemplate a major change of lifestyle. A couple of days later, after the market had rallied a touch off those historic lows, she e-mailed to say her financial adviser, who had preached long-term investing for years, sent her the following e-mail: "I write with a recommendation that we sell your investment securities -- stocks and bonds -- and park the proceeds in cash. . . . I am ranking capital preservation a higher priority now." You know what happened next. After the decision to keep her fully invested during the market had cost a fortune, the adviser managed to exit just before stocks rose 20%-plus. And so my friend's portfolio -- her livelihood, not a speculative plaything -- has been left in the cold. Given the slightest spark, the psychology of regret can force fund managers and retail investors into the market almost against their wills, and so can begin the next big bubble and boom. And as cynical as I am about company fundamentals and government intervention of late, this realization has helped turn me positive on stocks in the past month. It's not a matter of being bullish or bearish on the economy but being opportunistic for stocks -- more like a hawk than a lumbering ground-bound beast, scouring the savannah from the air for sustenance. Strangely enough, veterans will tell you this is actually how most bull cycles start: in disbelief and rage. You might think bear markets end when the economy begins to improve in a pervasive way and big companies start to report better earnings. But that's a fantasy, a children's fable. Just as bear markets begin when everything is great, bull markets begin when everything stinks. The inflection point comes when emotions run so high that economic and investment decision makers overcompensate.

Smart money' starts to bail on stocks' rally After more than eight weeks of a rally, stock market behavior is close to exuberance, say "smart-money" strategists who view factors such as rising participation and positive reactions to most news as tell-tale signs that it's time to take money off of the table. "Just like when too many participants bet on the same horse the betting odds on that horse go down, the 'betting odds' of making money in the short-run have been greatly reduced after eight weeks into this upside skein," says Raymond James market strategist Jeffrey Saut in his latest research call. "We have made a lot of money over the last eight weeks and continue to think the trick from here will be to keep that money," he said. Saut has taken his trading account back in a cash position, and has taken defensive positions in case of a market correction. So-called "smart money" investors tend to rely on contrarian indicators: Just as a social trend often starts fading after it makes the covers of many magazines, too much euphoria by too many market players often leaves little room for further upside in stocks. As the financial crisis and global recession drove stocks to 12-year lows, investor sentiment got so depressed that the slightest bit of better-than-expected news became potential fuel for stocks to rise.But after a two-month run, investors are now becoming more demanding. "Simply beating reduced earnings expectations is helping in the short term but in the long term, one must have earnings and revenue growth, not merely better-than-expected contraction," said Dan Greenhaus, market strategist at Miller Tabak. "In light of the broader issues facing the global economy, muted earnings and revenue growth should be expected and with it, muted stock prices cannot be far behind," he said.

You Get What You Pay For To be sure, the weight of money trumps all; indeed, this is how bubbles form. So while the fundamentals may or may not be rubbish, if there are lots of marginal buyers and no marginal sellers, the price will rise until equilibrium is restored. Trying to sell the top-tick is a game for suckers. That having been said, it is worth checking one's biases every so often. This is why Macro Man runs a medium term equity forecasting model that takes emotion out of the equation and attempts to provide an unbiased assessment of the factors that typically drive medium-term equity trends. And in the latest run, the 12-month forecast has turned down again. This is partially a function of the recent rise in prices, but also an acknowledgement that earnings quality is pretty execrable, recent beats notwithstanding. There is a lot of talk about how 'cheap' stocks are, but frankly, Macro Man just doesn't see it. Oh sure, it you look at operating earnings- particularly the operating earnings expected from bottom-up analysts- you can convince yourself that equities don't look too pricey. But this ignores the record divergence between operating and reported earnings, the latter of which contains the "one off", "extraordinary" write-downs (that seem to occur with quarterly regularity) known affectionately in this space as "turds."

March Lows a "Textbook Bottom," Buy the Dips, Says Schwab Funds CIO March 9 was a "textbook bottom" and investors waiting for the retest may never get back in, says Jeff Mortimer, CIO of Charles Schwab Investment Management, which has about $235 billion of assets. The outperformance of riskier sectors - smaller-cap, growth and economically cyclical names - has all the hallmarks of prior major bottoms, including 1974 and 1982, Mortimer says in the accompanying video, which was taped prior to Wednesday, the latest installment in the post-March rally. Although valuations never got as low in the current cycle vs. 1974 or 1982, the low inflation environment makes every dollar of earnings worth more, supporting higher P/Es, he argues. For investors who've been skeptical of the rally's staying power (like yours truly), Mortimer's advice is simple: dollar-cost average into stocks and use pullbacks to increase equity exposure to levels appropriate to your age and risk tolerance.

Bonds' 30-Year Hot StreakMr. Arnott's article has generated quite a stir in the investment world, where he has, in theory, turned a lot of received wisdom on its head. But American mutual fund investors, responding to last year's turmoil, are already voting this way with their wallets. So far this year they've withdrawn $45 billion from mutual funds that invest in the stock market, and put $68 billion into bond funds, reports the Investment Company Institute. Should you follow suit? Not so fast. Obviously bonds, especially Treasurys, held up well during last year's crisis. And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming. Treasurys don't look appealing. Short term bonds yield a miserable 1.9%. And long-term bonds, far from offering "security," are actually at serious risk from rising inflation. The past is the past. Those who bought long-term Treasury bonds in the late 1970s and early 1980s simply pocketed an enormous one-off windfall when inflation collapsed. It neared 15% in 1980. Latest figure: -0.4%. Consider what that means for investors. In 1979, 20-year Treasurys yielded 9.3%. So over its life the bond paid out $180 in interest for each $100 invested. At one point in 1981, 30-year Treasurys yielded an incredible 15%, thanks to runaway inflation in the 1970s. Investors demanded high interest rates to offset the expected loss of purchasing power on their money. But when inflation collapsed after 1982, those coupon payments turned golden because the purchasing power stayed high. Bond prices soared in response. Today, bond investors get no such deal. Ten-year Treasurys pay just 3%. And the 30-year 3.96%. If we get a sustained period of deflation, investors will still do well. But that's a bet, not a guarantee. It's just as likely that we'll end up with a surge in inflation instead. The economy seems to have staggered up from its death-bed (at least for now). And the mother of all fiscal adrenaline hits hasn't even entered the bloodstream yet. What would inflation mean for long-term bonds? The opposite of the lucky guy who bought long-term Treasurys in 1981 was the unlucky one who bought one in 1965, just before inflation began to surge. In 1965, a 20-year Treasury yielded just 4.17%. In the first year, the coupons on a $1,000 bond were enough to buy about 200 loaves of white bread. But by 1973 that was down to 151 loaves. And by 1980: A mere 80 loaves. The real return over the life of the bond was actually negative. Not only were investors not rewarded for saving -- they were punished. By the time they got their $1,000 principal back in 1985, it bought only a third as much bread as the same amount would have bought in 1965. Even when you factor in the coupons, the investor ended up with less bread than if they had simply taken the entire $1,000 down to the baker's in 1965. And notice we haven't even counted the cost of taxes. Longer-term Treasurys are often described as "safe" because the coupon payments are secure. But it's only half the story.

5 rules for post-recovery investing The Great Depression was long enough and painful enough to form the habits of a generation. The members of that generation became dedicated savers, avoiding debt, paying in cash and keeping both eyes focused on the long run. The current downturn, what I call the Great Recession, since it is already the longest recession since World War II, will do the same. In the new world that emerges after the recovery, people will save differently, spend differently, look at debt differently and think about the future differently. Differently how? Well, no one is exactly sure. It's awfully hard to figure out a change like this in the midst of it. But be sure of this: Every company in the global economy that doesn't have its head stuck in the sand is trying to figure out this new world. And for investors, getting it right -- owning shares in the companies that are in tune with this emerging world and avoiding the shares of those that do business as if nothing has changed -- will be the difference between profit and loss in the decade ahead. The Congressional Budget Office predicts the U.S. economy won't return to full-trend growth until 2015. And full-trend growth -- sustainable economic growth without rising inflation -- even then isn't going to be what it was before the global financial crisis. The Federal Reserve, which I'd place among the optimists on this issue, says full-trend growth isn't going to be the 3% annually of the pre-crisis economy but more like 2.5% or even as low as 2%. Harvard University economist Dale Jorgenson, who taught Fed Chairman Ben Bernanke, projects just 1.6% annual growth through 2030. If Jorgenson is anywhere near correct, the Great Recession would make the Great Depression seem like a picnic to many people. How is this important to investors? I'd suggest these five new-world rules to consider before buying shares in any company for the long haul: It's not "business as usual." Shy away from companies where the business plan going forward is simply a hope that things will go back to "normal" once the economy recovers. At a minimum, the company should recognize the world has changed. It's a good sign that Starbucks (SBUX, news, msgs), the classic pre-crisis consumer business, is groping for a new formula. The new value definition will be easier for some. Recognize that some companies have less distance to travel in meeting a new value proposition. McDonald's (MCD, news, msgs) needs to tweak its menus; Starbucks may need a top-to-bottom reinvention. Value doesn't simply equal low price. I don't know yet -- and neither does the company -- whether a new emphasis on organic and healthful food at reasonable prices will succeed in revitalizing sales at Whole Foods Market (WFMI, news, msgs), but the position makes sense in a post-recovery economy. Cost-cutting will be essential. A company such as Intel (INTC, news, msgs) that has built its long-term strategy on constantly cutting costs by constantly improving production technology is well-positioned for the new world. Low-cost producers like Nokia (NOK, news, msgs) also have an edge in this environment -- if they can combine low cost with perceived consumer value. Look for clear, flexible business strategies. The best bets are companies that have clearly articulated, flexible strategies for coping with this value shift. Procter & Gamble (PG, news, msgs), for example, has directed its advertising in developed economies to trying to convince consumers that its brands deliver more value -- they work better, contain less water, etc. -- even at higher prices. In developing economies, the company is cutting prices to win market share and to create brand recognition

Posted by dblwyo on May 10, 2009 01:47 AM |

Comments

Thanks for all the work. Hey we have moved on from investing in TIPS to looking at gold. Well, we are all still holding those TIPS bonds, but we are looking for other things. Sort of like those hypothetical monkeys randomly pounding on an infinite number of typewriters in hopes of producing one of Shakespeare's plays. Or just a practical plan for Chrysler.

The reason I am looking at gold is I expect another nasty sell off in the market, and over the last three years gold has been the only thing that moves up when the market crashes. Yes we could put it all in TIPS bonds, but remember you are talking to monkeys and their idea of reasonable risk is different from yours.


Do you have any thoughts on gold? Specifically, is buying gold now with the intention of selling it next year a reasonable investment?

Posted by: John K | May 11, 2009 10:25 AM

John - I haven't really given a lot of thought to gold. If you've noticed everything I do starts with analyzing the problem, breaking it down into pieces, figuring out it works all together and building back up an integrated concept that tries to capture the structure. Gold puzzles me tested against that standard.

There are a couple or three starting principles it might be worthwhile to reflect on. Having to do with the safety and flight to quality meme, the inflation hedge and so forth. Most of which in the common wisdom aren't well grounded IMHO BUT...also reflect the kind of rules for decision-making likely to drive the short- and intermediate-terms.

Let me do some more thinking and get back. Off the top of my head my guestimate is that gold might rally if my market thesis pan out.

Posted by: dblwyo | May 11, 2009 10:50 AM

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