Thesis: The U.S. stock market is unattractive on a multi-month to multi-year time frame, though the timing of a return to more attractive valuations, or even the fact of it happening, are uncertain. Valuations are high and stocks have gone more or less straight up for months. As a result, a more downbeat view of near-term economic prospects would be arriving at a difficult time for the market.
The major intellectual underpinning for this article is that stocks may be mispriced because investors are overvaluing corporate profits that come from unprecedented peacetime deficit spending fueled by unprecedented central bank bond-buying. I believe that these programs arose out of a crisis situation and aimed, and still aim, to prevent Great Depression II. Thus I believe that the excess Federal spending over revenues and Fed creation of new money has created corporate profits that deserve a low P/E, not a high one. Thus I wonder if the changing trends in the bond and commodity markets are correct. If so, stocks in the U.S. could do what stocks in Japan have repeatedly done during their long period of ultra-low interest rates, and rapidly reprice downward to a significant extent.
The above said, there are indeed good reasons for investors to remain in stocks, including all in. Jumping in and out, or out and then in if one agrees with the line of reasoning expressed herein, requires two successful decisions. That's not easy to do. Indeed, the resiliency of stocks, including the ones I use as examples of a disconnect between share price action and earnings trends plus insider selling, may very well represent Mr. Market gauging the future properly.
In any case, no argument herein is presented that other alternative homes for capital are especially attractive right now either. The main point of this article is to present in a rational manner a pattern of facts that have already occurred and that indicate that a meaningful downside event in stocks is now a reasonable possibility. Too many sensational media stories scare people by predicting a crash. I'm predicting nothing, just trying to make sense of a confusing situation.
Technical observation (brief): At this point, it appears that "too many" stocks now have good, great, strong or at least promising charts. The top part of the chart below shows the percentage of S&P stocks trading above their 200 day moving averages.
For at least the past 17 months, at least 60% of stocks have been above their 200 day moving averages. Now 90% are in that category. This would be fine if the economy were surging forward after a recession, as in 1983-4, 2003-4, or 2009-10, preferably associated with rising interest rates and rising commodity prices. All of those should be in gear during a classic bull market marked by rising production of goods and services, rising real profits, rising wealth levels, rising employment, diminishing poverty levels, declining numbers of people receiving nutritional assistance, etc.
Almost invariably in such a case, earnings estimates are rising rapidly for the current year and next year, and corporate profit growth is rapid. In the Keynesian era, those phenomena are also associated with surprising declines in Federal budget deficits or even a cash surplus. Unfortunately, most or all of those classic signs of a traditional bull market are missing now.
It seems that almost every publicly-traded manufacturer in the U.S. has become great in the eyes of Mr. Market. Does a company make consumer staples? Oh, great, they're all the top too. Overpriced legal drug products with 98% gross profit margins? Biotechs that might one day have a product on the market? Love 'em all. Do you compete to help doctors and hospitals go electronic? Oh great, 50X P/E isn't unreasonable. Do you sell a lot of stuff on the Internet and are named after a river in South America? Even better that you don't make any money, then we can just imagine how much money you will make when you drive all the competition into bankruptcy.
But seriously ... don't companies compete with each other anymore? Can they really all be winners? Yes, then no to the above two questions. Not only is something wrong here, it's been going on for a while.
The standards for a prudent investment have been defined down over the years, but one thing has not changed. It's still your money you're being asked to pay in order to play in this game, and if you lose it, well you've actually been promised nothing. Citigroup (NYSE:C) got a do-over to prevent the insolvency GM (NYSE:GM) didn't get to avoid; executives of companies whose stock price has fallen get new options at the new, lower price; but you, the individual investor, get none of those. You can get a 2% taxable yield on the SPY, which never ends and which promises you nothing, or you can get a 2-3% tax-free return with the security of a bond contract with an American municipality on an intermediate-term loan. The latter gives you a do-over with your money back, with interest, to potentially invest when stock valuations are low, not high (see below for more details), or to invest again perhaps when interest rates are attractive again.
Examples of the problem: Let's dissect an example or two where I think that fine, well-run companies have developed a disconnect between the trends of their fundamentals and their share prices; and where insiders appear to agree with my view that the share prices are now very attractive -- to sellers.
I actually admire these companies as being well-run entities that develop and market quality products, which is why I list them. No prediction of where the stocks mentioned below actually will trade is made or implied. I make these comments because in my 34 years trading stocks, I find what's going on in these and many other stocks to represent rare conditions. What I consider normal is that when business prospects turn down and insiders sell heavily, share prices do not rise and often drop.
Texas Instruments (NASDAQ:TXN) is the first example. This high-quality semiconductor company made a major acquisition of another chip company, National Semiconductor, in 2011. Beginning in the fourth quarter of 2011, TXN began announcing a string of sales and earnings disappointments. Earnings estimates for 2013 and 2014 for TXN show meaningful continued downtrends versus those of 30 and 90 days ago:
|EPS Trends||Current Qtr. |
|Next Qtr. |
|Current Year |
|Next Year |
|7 Days Ago||0.30||0.38||1.61||2.03|
|30 Days Ago||0.30||0.38||1.61||2.03|
|60 Days Ago||0.31||0.42||1.72||2.12|
|90 Days Ago||0.34||0.44||1.79||2.17|
Yet the stock is up 10% in the past 3 months, and over 25% from last fall's low. Are investors following the lead of insiders, who recognize that business prospects are actually about to go gangbusters?
No. Also from Yahoo! Finance for TXN:
|Insider Purchases - Last 6 Months|
|Net Shares Purchased |
|Total Insider Shares Held||916.97K||N/A|
|% Net Shares Purchased |
This indicates that TXN's insiders sold more than half their stock within the prior 6 months. No insider buying was seen.
Perhaps TXN has been increasing its value in other ways?
It appears not.
On this summary of the TXN balance sheeet below, the right hand column reflects the balance sheet as of December 31, 2010, and the left hand column that of 12/31/12:
|Total Stockholder Equity||10,961,000||10,952,000||10,437,000|
|Net Tangible Assets||3,899,000||3,394,000||9,232,000|
Tangible assets have declined by more than half- over $5 B- while equity has increased (see appropriate lines on the above linked balance sheet). This is due to cash out the door being replaced by the value of intangibles and goodwill that Texas Instruments' management placed on National Semi's assets. Is a writedown coming?
The market values TXN at $40 B. This is more than 3X annual sales, which are growing slowly, 4X stated book value, and 10X tangible book value. TXN's earnings in 2012 were below those of 2006 (nominal dollars, worse adjusted for inflation). Sales and earnings per share are running below those of 2010.
Because TXN is trading so far above the value of its assets minus liabilities, it must earn tens of billions of dollars that will in time be distributed to its shareholders in order to actually prove to be worth its current valuation. (Then we need to discount for present value.) TXN may eventually prove to have been worth this price, but it also could prove to be seriously overpriced today. Texas Instruments is an intensely competitive industry riven by deflationary forces.
Why is TXN not selling at 10X trailing earnings, just like the stock of Apple Inc. (NASDAQ:AAPL), probably the strongest company in the world?
The public is being asked to gamble with its savings on these names, but insiders are not. It's not fair, and we should beware. Once again it's important to point out that we are not dealing with bubble prices; it is not March 2000 all over again.
In other examples, Colgate-Palmolive (NYSE:CL) stock has soared, but earnings estimates for 2013 and 2014 have declined. PepsiCo (NYSE:PEP) stock has soared. Earnings estimates for 2013 and 2014 have - you guessed it- declined.
CL insiders haven't shown much enthusiasm for their employer's shares lately (PEP is similar):
Net Share Purchase Activity
|Insider Purchases - Last 6 Months|
|Net Shares Purchased |
|Total Insider Shares Held||1.32M||N/A|
|% Net Shares Purchased |
Insiders have lowered their ownership in CL at a 31% annual rate. But no matter. They will receive more options and/or restricted stock. And if the share price drops, that's fine too, because then their new options will have lower strike prices. However, there are no provisions to benefit shareholders if the stock price somehow drops- which now appears impossible if one looks at the relentless price rise.
It is when a price surge appears unstoppable that any security may be especially dangerous.
But isn't the Fed "printing" money? (Yes.) Isn't that inflationary? (Yes.) Aren't stocks good inflation hedges? (Only when they are not valued as such, as in 1948 and 1982. Otherwise, they are poor inflation hedges, as they were in 1965. As the chart below suggests, this may be 1965 or 1968 from a fundamental valuation standpoint.)
Nominal projected earnings expectations are being lowered, not "real", so they take the Fed's money-printing into account.
Many stock prices are now experiencing P/E expansion fueled by general optimism, Fed actions and declining interest rates --in the face of deteriorating business conditions and heavy insider selling.
What's been occurring is called distribution. Insiders are selling as operations struggle to meet expectations, and the public has gone on margin again in a big way to buy from the insiders.
Saying the above, if it is correct, is almost worthless as a trading tool, and as always is an imperfect guide to the future. The future may always be different from the past. So let's discuss timing and what has been changing lately.
Timing: Gold: Gold's price collapsed Friday and is collapsing more this Monday AM in U.S. and London trading. This is being accompanied by a similar move in silver, and both violated long-term (two or so years) triangle formations that could have turned bullish but now look quite bearish. When accompanied as they were by deteriorating prices for copper, oil and platinum, the obvious thought is that the market is pricing in either deflation or at least less inflation than it previously was. Either situation is a red flag for nominal profits and nominal GDP.
Perhaps the frozen and impaired funds in the two troubled Cyprus banks have produced a seller or sellers who needed to raise cash, and have been dumping gold in response. The situation in Cyprus worsened last week, as the losses from the banking mess were reported last week to be much larger than thought. PIMCO's CEO Dr. el-Erian explained this, as reported on April 12. The blogger Wolf Richter details the situation in more depth.
Whatever the cause, these drops in the metals suggest that trouble may be brewing somewhere in the globe, and at some point the U.S. stock market might cease to act as a safe haven.
Large sudden downside moves in gold are often poor portents for stocks. On February 28, 2012, gold also dropped about 5% in a single day. That was near the peak in the SPY, which was at a then-rally high of $137 that day. It traded under $130 three months later and was under $136 as late as November.
Another time when gold was already in a downtrend as it has been since peaking in 2011, and then collapsed, was July-August 2008. Presumably the combination of housing deflation and stressed, forced sellers brought gold's price down that summer before the crisis hit in September and October.
When gold falls hard when the authorities say they are fighting deflation, the fact of its fall may be a warning sign of greater deflationary problems.
This is quite different from the early 1980s, when the authorities were fighting inflation and desperately wanted lower interest rates. Then, the drop in gold from over $800 by half was evidence of a general and desired cooling of inflation.
Timing: Industrial commodities. The renewed weakness in precious metals has been accompanied by weakness in copper, oil, platinum and other industrial commodities. Brent crude and West Texas Intermediate oil are both in bear markets compared with both their 2008 peaks and with their 2011 peaks. (Gold and silver may simply be "catching down" to these other commodities.) Copper's price continues to erode. I wrote about it on April 1, noting a divergence between its price action and that of the SPY. Since then, the SPY is up 2%. Copper is falling hard Monday to new reaction lows, so the divergence has widened farther; and large speculators, who presumably comprise smart money, continue to vigorously short the metal. This is one commodity that could go in either direction, or none at all, but its ongoing drop is a danger sign that global economic activity is less than anticipated.
We will just have to see whether these are real signals or just "noise".
The action in the commodities is, however, in accord with that from the bond markets.
Timing: Interest rates: With the above deflationary hints, let's analyze the following chart comparing the SPY with the 10-year T-bond (TNX), from Yahoo! Finance.
As interest rates dropped sharply in the summer of 2011, correctly forecasting the end of the strong global and booming U.S. economy that represented true but all-too-brief recovery from the Great Recession, the stock market decoupled from bonds. Stocks began correctly forecasting more economic growth than the bonds were forecasting- but robust economic growth did not occur, so the diverging stock and bond markets each had a point. But now it may be that the message of commodities is signaling that Mr. Bond actually was making sense:
Employment Growth Hits New Low
Year-over-year growth in nonfarm payroll jobs has now dropped to a 19-month low, and household job growth has dropped to an 18-month low.
The small forecasting firm RecessionAlert recently estimated a 24% probability of the U.S. currently being in recession. (That was before Friday's data, so their updated recession probability might be higher now.) So between RecessionAlert, ECRI, and recent disappointing economic data, we cannot rule out that a mild U.S. recession may have begun. It is generally impossible to recognize the onset of a recession in real-time. Few if anyone did it in 2001 or in December 2007. So when it's a possibility, stock prices should consider the downside if one is about to start.
Valuation: Recession or not, Mr. Market could change his tune and take a dour view of the U.S. economy one of these days. After all, he once was a moody, manic-depressive fellow. And he likes to mean-revert.
Instead of always forecasting brighter skies, he may point out that our still-anemic economy occurred despite maximum Fed efforts and still-large Federal deficits- and thus he now feels it deserves a lower P/E. He suddenly decided to do this for the shares of Apple Inc. last year. by the way, with no clear reason.
The overvaluation of stock prices by one version of q and CAPE (measure of asset value; Shiller P/E) might even finally, over time, give way to the first sustained undervaluation in about 25 years:
Part of the text below this graph reads:
As at 12th March, 2013 with the S&P 500 at 1552 the overvaluation by the relevant measures was 57% for non-financials and 65% for quoted shares.
Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.
Some day, stocks may revert back to more normal valuations.
Sentiment: It's amazing what a bull market and central bank bond-buying can do, even to (former) bears. For example, ECRI stated in the late summer of 2011 that the U.S. was either in or soon to be in a recession. They accompanied that with a press release to the effect that if you thought the economy was bad at that time, just wait until you see how horrible it was going to be when this recession hit. Now, they have changed their tune and say we are in a mild recession. They point out that three of the last 15 recessions have been associated with bull markets, and they specifically now analogize our current situation to the great bull market that carried on through the 1927 recession into summer 1929 (p. 12). But when they made their well-publicized Sept. 2011 recession call, the stock market promptly dropped-- and headed up again until now. Why should we not think they are calling not a 1927-9 raging bull but rather are top-ticking?
The most common sentiment I see comes from ilene this past weekend:
Typically the public enters the market only after a large run up, just in time to buy at the top. Investors might get luckier in today's situation if American stocks start behaving more like the Nikkei 225 index. U.S. equities have plenty of room to run simply as hedges against massive money-printing by Chairman Bernanke.
I tended to share that view coming out of the Great Recession, but I changed it in May 2011 as documented in numerous blog posts such as Goldman Wrong on Rates, Zero Hedge Wrong on Oil As Deflationary Side of Biflation Begins Its Ascendancy on June 8, 2011. In that article, I argued against Goldman Sachs' call for rising rates and against ZH's call for rising oil prices. Since then, I've felt that there were powerful inflationary and deflationary forces contending for dominance, and that the outlook for the markets was unusually uncertain.
The "hedge against money printing" argument for stocks only works when their price has not already adjusted for the Fed's actions. A better set of reasons than mere money-printing why stocks have done well since 2011 includes a combination of declining interest rates, resiliency of the U.S. economy, economic weakness abroad, and trend-following behavior in the stock market-- but not really because of inflation, which has decelerated from its 2011 pace.
Here's one more example of "reluctant bull" thinking, also from the haven for short-sellers, Zero Hedge, where ilene posted her article. A gentleman named David Fry has a blog and posted on ZH Saturday. One of his many charts showed that he is long retail without believing in the story. Perhaps he just doesn't want to fight the Fed (or the tape):
Zero Hedge and some of its contributors have capitulated ("Tyler Durden" turned bullish on stocks a while ago for the not-fighting-Fed reason.). The leading blog for short sellers is running with the bulls, at least accepting their dominance. Don't fight the Fed; don't fight the tape. But that's so 20th century. It was a fresh idea in the 1980s; RIP Martin Zweig. But all theses become discounted into prices over time. Maybe it's past time to retire it. It stopped working in Japan in their post-1999 era of zero interest rate policy. Why should it work in the U.S. anymore?
Maybe it's time to fade those who merely follow the Fed and follow the tape.
Various prominent bearish talking heads have capitulated. The former bear David Rosenberg capitulated last year. Gary Shilling, who forecast a new recession at least for 2011 and then again for 2012, wrote a piece for Bloomberg.com recently which was surprisingly upbeat.
Stocks and related financial assets such as hot commodities such as silver become more attractive to "investors" when their prices have risen. This is illogical. It does not occur in the world of bonds, where lower interest rates make bond buyer less interested in a bond.
It's even unclear that the Fed is A) protecting stockholders, and B) will continue to do so (even if it has done so up until now). The Fed is buying bonds, not stocks (at least not that we know). The Fed has not prevented two stock market crashes in this millennium. The Fed is a creation of the Federal government. Ben Bernanke is a Federal employee. In a pinch, the Fed will support the Federal government and the banking system before the stock market. At least, that's what I think.
Between the end of 2008 and the end of 2013, the Fed will have created, say, $3 T of new base money between late 2008 and the end of 2013 through its QE programs. Yet please calculate how many trillions of nominal value of stocks, bonds, real estate and physical commodities have been created since then. It is several times the amount of Fed money-printing. And this allegedly toxic new money: where is it? Much of it is in non-borrowed reserves- at the very Fed that created them. How inflationary are those reserves? The Fed is paying the banks 0.25% per year on those reserves. Is one quarter of one percent growth rate of those reserves inflationary? Yes, at the rate of 1/4% percent per year. That's it - until the new Fed money actually gets multiplied through the workings of the banking system or until the velocity of money picks up.
In any case, I believe that lenders can create inflation by the magic of fractional reserve banking using new reserves that they themselves create, so the Fed's actions are not needed to cause inflation.
Deflationary pressures still abound.
Significant overhangs of residential housing and commercial real estate remain. Small businesses are not thriving. Their operations remain at recessionary levels. So does the jobs picture as judged by Gallup, which remains at levels of August-September 2008. The Bloomberg Consumer Comfort Index is hovering marginally above the recession level of -40; it is below the level of both 4 weeks ago and one year ago. The U. of Michigan consumer confidence survey for April just hit a 9 month low. Etc.
Few lenders need more deposits because most really don't have enough good lending opportunities relative to their lending capacity. As of this earnings season's bank quarterly reports, it's apparent that this situation continued in force through yearend. This is similar to Japan's post-bubble situation, which experienced huge surges and then huge declines in stocks.
Thus, while anything may come to pass, the latest trends suggest that deflationary forces have risen.
In view of all the above, why should stock prices hedge inflation? What happens if they instead begin to hedge deflation (or, "disinflation", i.e. a further decline in the rate of inflation), as both commodities and bonds are now signaling? Wouldn't stock prices then head much lower? And what if inflation really takes off and interest rates follow sharply higher? Might stock prices then drop to allow their valuations to compete with bonds, which could suddenly look much more attractive? And if hyperinflation appears out of the blue, aren't gold/silver/oil better than stocks?
The above questions arise now because share prices are historically high in relation to the value of their underlying assets minus liabilities and because corporate profitability has temporarily been raised by the rare combination of unusually stimulative fiscal and monetary policy. In contrast, when stocks are cheap, they are resilient to recessions and can better withstand adversity.
To be sure, yours truly has no certainty of when, whether or if the primary trend in U.S. stock prices will change. There was a presumably intelligent human or algorithmic buyer for every share of stock I have ever sold, including last week (mostly on Friday). But as one who is more concerned with preservation of capital than gaining excess returns on capital, and not answering to a committee about whether I'm meeting a benchmark, that's not a problem. Every time I've seriously lowered my stock allocation over the past 13 years, I've been early, so having done so last week, I'm expecting a strong stock market from here! And if the facts change, I will change with them.
Conclusion: The dominant theme of not fighting either the Fed or the tape may be changing, given the combination of falling commodity prices, falling interest rates, and an anemic economy that might be weakening further. Because stock prices are both historically high by q and CAPE and are also extended in price, downside risks are greater than usual.
Unusually stimulative fiscal and monetary policy can only continue if an economy continues to be weak. Stock prices thus have numerous hurdles in the months and years ahead.
Disclosure: I am long AAPL, C. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am not an investment advisor. Nothing herein is investment advice.