A Bear's Best Effort At Making A Case For The Bulls

Includes: SPY
by: Joseph Stuber

Readers constantly ask me what I would have to see in order to change my bearish sentiment and get bullish on the market. It is a fair question and one every trader needs to consider. After all, I constantly make the point that every trade must have an exit strategy and every investor must consider the possibility that his initial assessment of market direction may at some point prove to be wrong.

At times there is a fine line between being committed to a trade and being in denial. I readily admit to a bit of frustration at the moment as the market just keeps moving higher. For the last few months, I have joined two other market analysts in a daily conference call. My inclusion in the discussion is purportedly for the value I add to the discussion based on my understanding of monetary policy.

My only contribution to the discussion on Tuesday was the point made by the following chart on SPY:

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My point was that the probability of moving much higher is substantially refuted by statistical probability. Since May 7, this market has been above 2 standard deviation on the 90-day chart. That is highly unusual and has a probability of about 5% - in other words 95% of the time the market will trade below 2 standard deviation.

Occasionally the close does exceed the 2 standard deviation band but I can't find an instance going back for decades where the market has stayed above the 2 standard deviation band for 11 straight trading sessions. My call for a high back on April 11 was based on the generally reliable assumption that the market tends to pull back from the +2 standard deviation level. That call was a good one in the very, very short term as the market did pull back by a full standard deviation. Thereafter, the market went into a pure parabolic rise.

So, here is what I am left with. I am first and foremost a fundamental analyst but I do recognize that my view of the economy is not what makes a market move. To the contrary, investor sentiment and only investor sentiment is what makes the market move. When we get into parabolic price move territory we enter an area where a severe imbalance occurs in the make-up of the market. Liquidity is needed to assure a stable market as to price and that requires a rough balance between potential buyers and potential sellers.

That balance disappears in a parabolic move as all sellers disappear. It is situations like this that create bubbles and in all instances the imbalance - at some point - moves from the buy side to the sell side and a crash ensues. So to the point - is there a case to be made for stock prices continuing higher other than the fact that sentiment is at the present very high and the bid side of the trade has pushed the price to an extreme that I can't find replicated in the S&P 500 in times past? To answer that question I am going to look at a number of indicators to see if a LOGICAL case for a continuation of the bull move can be made.

We will start with the chart below. It is inflation adjusted to 2013 dollars as the constant and plots S&P 500 price, sales and profits:

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I don't think a case can be made for higher price and profits by looking at this chart, but then one can't make a case for lower price and profits either. One could argue that in 2007 we were peaking and therefore we may be doing so again as we are now close to those 2007 levels but that isn't really a valid argument since we know that the reason we collapsed off the 2007 highs has more to do with the mortgage debt crisis than price, sales and profit levels.

The chart below is the real earnings as a stand alone chart. Again it is inflation adjusted using 2013 dollars as the constant:

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Current earnings are under the all-time 2007 high of $94.77 at $87.61. The inset in the chart above shows that real earnings peaked just short of the all time high at $89.74 and has actually rolled over and pulled back $2.13. That is a 2.4% pull back from the 2012 high suggesting a trend reversal but top line sales can push the earnings back up, so there is no reason to conclude that the trend will continue to move lower. Perhaps we can't draw any conclusions here either.

Let's look at the standalone chart for sales. Perhaps that will show us a positive trend:

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The chart above does in fact show that sales - although flattening out a little - hasn't indicated a peak and a roll over. This is the best argument yet for a continuation of the bull market and if top line sales do expand further then a higher stock price is reasonable even without multiple expansions.

To see how significant the flat line is, we can look at the data adjusted to reflect rate of growth. Here is the chart:

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Well, this doesn't make a very good case for getting further price increase through a continuation of the sales growth trend. That said, we can't really draw any conclusion here for the simple reason that we are still in positive territory - in other words we have slowed down a lot on sales growth and in fact we have peaked and started to move lower but we are still in positive territory so we are still growing - albeit at a much slower rate since peaking in December, 2011.

One could argue that the slowdown in sales and earnings growth is problematic since stock price is climbing as these other metrics seem to be slowing down and maybe even retreating a little. That is not necessarily a valid bear argument. It may be that price needs to catch up to sales and earnings and therefore higher price is justified. A close look at PE ratio is useful here. The following is inflation adjusted 10-year average or CAPE:

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Again we find that the PE ratio is at an extreme level but below the levels of 1929, 1999 and 2007. In other words, we can go higher and still remain within the historic range at least at its extreme. Additionally, with a ZIRP policy in place, there is at least a reasonable expectation for investors to push stock price higher in light of no viable alternative to achieve yield. It involves risk of course, but perhaps no more risk than fixed return assets at this point. Simply stated, fixed income assets at current yield have substantial risk of loss of principal - perhaps as much as equities, meaning that there is no reasonable alternative.

That of course doesn't mean there is no risk as all asset classes have higher risk than normal but on a comparative basis, equities are the best asset class. This is a reasonable basis for being bullish stocks and is the primary argument the bulls cite for why stocks have further to go. The next chart reproduces CAPE with the mean and standard deviations plotted against the data:

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Using the CAPE average 10-year earnings number and extending the multiple to the +2 standard deviation band and thereafter recalculating the S&P 500 price, one gets an outside extreme S&P 500 price of 2091 - approximately 420 points higher than current levels. That is another 25% higher than current price and assumes a static S&P earnings number going forward.

Is it reasonable to assume a high in excess of 2000 on the S&P? At the current rate of climb, I do think we must see some indication that the economy is able to sustain itself without fiscal stimulus going forward as it will take 18 to 24 months to achieve that 2000 level. Keep in mind, we did go partially over the "fiscal cliff" and we are seeing the impact of this in a number of areas. To sustain the bull market going forward we must achieve escape velocity.

Making a case for reaching economic escape velocity

With regard to achieving escape velocity we need to take a look at the QE argument - in other words, will QE work to devalue the dollar and in so doing create a nominal gain in stock prices? This is a potentially valid bull case argument but it requires an increase in M2 and M2 velocity.

Here is M2:

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M2 is constantly expanding, but so is GDP and when the 2 metrics climb at a rate that is relatively close, inflation doesn't occur. I like to define inflation as too much money chasing too few goods and when that situation exists, the nominal price of goods and services as reflected by GDP moves higher. Here is a look at GDP:

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GDP is moving higher along with M2 indicating that dollar devaluation and inflation aren't really working to drive asset prices. Both metrics have moved higher by roughly $2 trillion since the end of the recession.

Here is M2 velocity:

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M2 velocity is the key to GDP growth and at the present, M2 velocity is at a multi-decade low. The reason is really pretty straightforward and has to do with the savings component of M2.

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This chart explains why M2 velocity is at multi-decades' lows. Savings is a component of M2 but money being saved is not money being spent in the economy to drive GDP growth. M2 has expanded by about 20% since 2009 and savings by double that amount.

One can make a case for the bull side by asserting that savings in dollar terms peaked in late 2009 and has flattened out since then as the inset of the 5-year chart shows. Some do make the argument that "animal spirits" are being revived and that will drive GDP growth as consumer confidence improves. In other words, if income is being spent and not saved M2 velocity will climb as will GDP. This is a completely valid argument and the key from a forecasting perspective is to get it right - in other words will the savings rate move lower, higher or remain static?

To get an idea on the prospects for continued GDP growth, a look at Personal Consumption Expenditures is informative. Here's the chart on PCE:

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There is nothing in the PCE number that suggests a problem at all but at the same time PCE offered no indication of the market crash that started in 2000. Unlike in 2007-08, the market crash in 2000 shows very little slowdown in PCE.

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How about housing - can a revived housing industry fuel an expansion in GDP that will push stock prices higher. Here is a look at the Composite Home Price Index chart:

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No doubt we have turned higher for the moment but I don't think this is the fuel needed to reach economic escape velocity. First, housing was in a bubble created by extremely lax credit requirements and a mandate to the GSEs to increase the participation rate level of low income homeowners - a really stupid idea that fueled higher prices based on easy money. The crash in home prices suggests that home prices got way ahead of the curve and created a bubble. In other words, the current home price index is probably reflective of a reasonable value and the post recession high was a huge distortion. If that is the case, then a rebound in housing is not likely to occur anytime soon.

Here is another metric worth considering - the amount of household debt service as a percent of disposable personal income:

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The chart can be used to make the bull case and the bear case. The bear case is that consumers feel less confident - in other words, they are not spending as much of disposable income as they have in the past to buy goods and services, choosing instead to pay down debt. As the chart shows, we are at the lowest levels since 1980 on this metric. The bull case is that from these lows there is only one way to go and that is up. Of course, we could have said the same thing for the last 2 years and we would have been wrong.

Another argument for why debt service as a percent of disposable income is so low is that incomes have been moving higher. Here is a chart of the Real Personal Income:

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What we can garner from this is that debt reduction is not the only reason debt service as a percent of disposal income is at multi-decades' lows. Incomes have climbed since the end of the recession, so all else being equal, debt service as a percent of income would naturally fall. Of course, another reason for the debt service being at multi-decades' lows is the drop in the carry cost of debt as interest rates have been at all-time lows.

The next chart makes the point that debt service as a percent of disposable income is so low is due in part to the net reduction in household debt. Here is the chart:

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What is most relevant in this chart is the rapid acceleration in household debt from 2000 up to the pre-recession peak. This next chart puts the matter in a better perspective:

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As you can see from the chart above debt from about 2000 until the beginning of the recession accelerated at an unprecedented rate. We have made some progress over the last few years toward deleveraging, but is it enough? As I have stated numerous times over the last several months, the massive debt accumulation was the result of an easy credit policy promoted and actually mandated by a Congress that directed GSEs to expand the numbers of low income mortgages.

Some progress has been made to correct the excess but debt to disposable income and debt to GDP remain extremely high in the context of historical norms. There are two possible scenarios that could develop from here. The bull case is that we have deleveraged enough and banks will begin to loosen lending standards which will expand M2 at a rate that outpaces GDP, driving the cost of goods and services higher and thereby inflating out of the hole once again. The second scenario is that banks continue to impose strict lending requirements and the deleveraging process continues until debt is brought back below 100% in relation to disposable income.

These aren't normal times and the measures being taken to avert deflation are extraordinary and the gains are minimal. That isn't really the subject of this essay though - what I am trying to do here is present a bull market scenario and the only one I see is to simply inflate out of the hole we are in and that is clearly a possibility if banks loosen credit standards and start lending again.

The best metric for gauging the banks inclination to lend is the excess reserves chart:

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This is the best chart I know of for demonstrating the extremes we have gone to in order to avoid deflation, deleveraging and recession. Consider that the Fed has flooded the system with excess liquidity and the banking system has summarily rejected the Fed's attempt to get them to expand M2 through more lending.

This next chart tells the whole story - the Fed in conjunction with massive deficit spending has impacted corporate profits but not the economy:

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The chart above plots the S&P 500 against the rate of change in the CPI. The correlation from January 2007 through June 2011 was a positive .68. The correlation from June 2011 through April 2013 was a negative or inverse correlation of .84. The Fed has fought with all the tools they had and some they didn't even know they had in the beginning to stave off deflation.

The chart above suggests they are losing the battle on the deflation front. This situation should be more than a little disconcerting to the Fed. One has to ask what more can be done to avoid deflation through monetary policy. For those who don't understand the consequence of a deflationary spiral, the following graphic illustrates the impact of deflation. It is decidedly the worst of all possible scenarios.

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Here's an excerpt from an essay by Paul Krugman on deflationary spirals:

Among the growing number of observers who now regard deflation as a serious risk for the world's major economies, there is a subtle difference of opinion about the sources of that danger. One view - which is the one that I have espoused for Japan, and set out most recently in my piece Can deflation be prevented? , is that deflationary pressures are essentially structural: the economy's equilibrium real interest rate is negative, and so even with a near-zero nominal interest rate it remains underemployed and generates gradual deflation unless policymakers somehow manage to create expectations of enough inflation to get the real interest rate down where it belongs.

I think Krugman is making a very important point regarding economic theory and how it is implemented in the real world with policy. The underscored portion of the statement above says it all - if policymakers can "create expectations" of inflation then inflation will occur. Why - because we will spend now believing that to wait means we will have to pay a higher price in the future. More important though is that we will borrow in order to buy today if the inflation rate is higher than the cost of borrowing.

That is what the Fed has tried desperately to do - "create expectations" of inflation. It is also what they have failed to do despite massive and unprecedented attempts. Here is an excerpt from an article entitled Irvin Fisher's Deflationary Spiral:

The real rates are simply the real interest earned by savers (in terms of actual purchasing power) and simultaneously, the real interest "lost" by borrowers.

If we have deflation in the future, at say -2.5%, and if Fed Chairman Bernanke has interest rates down to 0.1% (for example) then we get real rates as:

r = 0.1% - (-2.5%),


r = 0.1% + 2.5% = 2.6% !

In other words, despite near-zero nominal interest rates, we have positive real rates. This encourages savings, and strongly discourages borrowing. It simply makes sense to save. Even if CDs pay low rates (the nominal rates) the accompanying deflation results in a high effective real rate! It "makes sense" to park your money, and not to borrow.

Here is the question - do the metrics I have pointed out above suggest that the Fed has managed to "create expectations" of inflation. The answer is yes as it relates to stock investors and traders and a decidedly emphatic no as it relates to the real economy. Are we likely to get a change in those expectations based on the parabolic rise in stocks in the last 6 months? Maybe and that is what you better hope and pray for if you are banking on higher stock prices from these levels.

Concluding thoughts

I did my best to make a case for the bulls in this essay. I think the presentation is objective and sets forth the facts and I think my comments on each of the metrics are void of any bias. Here is what it all comes down to - we have pushed to the outer limits of stock price levels based on corporate profits. We have reached a point where further gains - if they are to be justified - must come from an increase in profits or in the alternative, a significant expansion in P/E multiples.

The dilemma we have at the moment is that a number of indicators are suggesting a problem with profits moving forward. In other words, we must see a renewed vigor in the economy where borrowing and spending take center stage. As Krugman so aptly explained, we need to "create expectations" of inflation in order to avoid deflation. At this point, it can be argued that the Fed has failed in this endeavor as inflation has been falling for almost 2 years now and in the face of an increasingly aggressive attempt on the part of the Fed to create inflationary expectations.

Here is the problem - almost all concerned seem to be suggesting that fiscal and monetary policy must be held in check going forward. We have already implemented policy shifts regarding fiscal stimulus and deficit spending and the talk of slowing down monetary policy by backing off on Fed balance sheet expansion has also taken center stage of late. You can argue that it is all talk and the Fed won't do it and I will readily agree that you are probably right but the question still remains will it even matter going forward.

The point is the Fed hasn't been able to create inflation even with aggressive monetary policy - a 4 fold increase in the balance sheet - as inflation has been drifting lower as the Fed's efforts have increased. What we have now is disinflation - a negative rate of growth but a rate that is still in positive territory. At the current rate of descent we will be in negative territory in another few months.

Here is what you must decide - will the current deleveraging trend stop and re-leveraging begin? Will banks loosen credit standards and move back to an easy money policy? Will qualified borrowers come out of hiding and begin to invest and borrow? That is the only way this bull market can continue - at least on sound footing. That said, we may still have further to go from here but if we do so without these metrics changing course, we are in pure bubble territory going forward from these levels.

Disclosure: I am long UVXY, FAZ, TZA, TECS. 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.