Introduction: Most data points that I follow and that have marked intermediate or major market tops since I have began investing in 1979 is now in place. I think the stock market as a whole is now a place for risk-takers only, aka gamblers.
This article is only going to refer to U.S. markets and the U.S. economy unless otherwise specified.
The markets are like the weather. They and the economy will do what they will do. In this era of Federal Reserve intervention in the financial system, it's fair to say that the future is unusually uncertain. Also, I'm well aware that bull markets exist to confound prior patterns that marked prior tops. In response to that fact, all I'm doing is explaining why the backdrop now suggests that if prices rise without much participation from me, fine. I'm not short anything. What I'm guessing is that better entry points will occur. Sometimes that is at higher prices as the fundamentals accelerate upward. That would be nice, indeed.
Nonetheless, here goes a list of some points that may have not been heavily publicized.
1.Corporate profit trends poor: Per the Bureau of Economic Analysis, as of May 30 (I think these are nominal, not inflation-adjusted data):
Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) decreased $43.8 billion in the first quarter, in contrast to an increase of $45.4 billion in the fourth...
Domestic profits of nonfinancial corporations decreased $8.8 billion in the first quarter, in contrast to an increase of $24.8 billion in the fourth.
Domestic profits of financial corporations decreased $2.0 billion in the first quarter, compared with a decrease of $3.5 billion in the fourth.
2. Business sales weak: A very broad measure of business sales has been flat in nominal terms since last fall:
These data are not adjusted for inflation. A more general homepage for this index allows you to scout around more.
What these data are is the aggregate of three major monthly surveys that individually get more attention: retail sales, manufacturing, and merchant wholesalers (note there is overlap between them). The combined sales are about 1.27 trillion dollars monthly. Sales are flat since last September (seasonally adjusted). The table also shows a similar trend in 2008 or one could reasonably point to November 2007 as the peak month for sales and analogize that month to September 2012.
The main point relative to interest rates is these sales numbers are nominal. They are not adjusted for inflation and they have been flat for months; year-on-year trends are also weak and have been decelerating.
These data suggest at best a growth slowdown and at worst a recession. They are, however, subject to revision and in any case may be getting ready to burst upwards again even if they are not substantially revised.
3. Lumber prices in bear market: Per FINVIZ, here are the latest about year-long, and then multi-year, data for lumber futures. This data primarily reflects domestic supply and demand, as opposed to "Dr. Copper," which is more heavily influenced by China and other countries.
Prices on this particular type of lumber are unchanged from 13 months ago as well as below the highest price reached in 2010.
The multi-year look shows several prior declines. In each case, the economy and stock markets both followed to the downside. Lumber peaked in or around July, 2008 -- a good time to take the "under" on the economy and the markets. It then peaked early in 2010 and 2011, and we know that soon after, stock markets dropped and the Fed was forced to resume either quantitative easing (2010) or its cousin, Operation Twist (2011).
Perhaps more importantly, Random Lengths shows bear markets in two different and broader measures of lumber prices:
Average of 15 key items
Something may be going on with housing given the above trends.
4. Gallup's Job Creation Index: It's stuck around +21. This might sound good except that it is basically at pre-Lehman 2008 levels: i.e., recessionary. (This was also the same period in which business sales turned flat.)
5. Homebuilding stocks "too strong," not tracking lumber prices: Despite the surge in interest and mortgage rates, homebuilding stocks feel little pain. Toll Brothers (TOL) is trading at about 40X current fiscal year and about 22X next FY consensus earnings estimates as reported by Yahoo! Finance. Why? The index of homebuilder stocks (ITB) is up more than 4X from its low even though the industry is rebounding solely due to massive governmental assistance. This is a negative divergence. It may reflect over-optimism.
6. Unusual surge in interest rates: The percentage surge in interest rates is of a degree that has marked major stock market tops, and interest rate peaks, before. The lower interest rates are, the more a percent change matters. For example, when interest rates are 20% in a high-inflation country, raising them to 22% in one step is a fairly minor move. However, going the same absolute level now from a Fed funds rate of 0.11% to 2.11%, or from 2.3% to 4.3% on the 10-year bond, would be quite something.
If we go back to the late '90s, we see a similar percentage move on the 10-year bond from the spike bottom in October 1998 to the top in early 2000 that we have seen from July 2012 to today. That top in 2000 also marked the top for the NASDAQ and the SPDR S&P 500 ETF (SPY). An even briefer spike in rates of similar percentage magnitude occurred in spring 1987 to the peak in October; rates peaked just as stocks did.
7. Other parallels to the 1999-2000 period: In each case, the U.S. acted as a safe haven to an important part of the world, Asia and countries in other regions then and much of Europe today. In each case, the U.S. was the beneficiary of declining world demand, "importing deflation." Gold and silver prices declined along with inflation. Each period was accompanied by intense stock speculation. Then it was tech-media-telecom. Now it is more diffuse. Today it involves slow growth/no growth utility stocks trading at growth stock multiples, and on the other side of things, we see countless money-losing biotech stocks trading on hope but with valuations that reflect big successes. Of course, we also have some of the same things that went on in Y2K, such as Amazon.com (AMZN) trading at bubble valuations but relentlessly marching higher.
In each period, the declining trend in interest rates that had helped to sustain both the bull market and the business expansion reversed with a frenzy, as investors disdained the security of getting their money back to purchase and trade much riskier stocks and bonds that ultimately offered both capital losses and insecurity.
8. Tech bubble similar to finance bubble: Tech crashed and after a couple of corrective years, surged again into the 2007 recession and subsequent crash. Similarly, financials and housing-related stocks led the pre-Great Recession bull market, crashed, entered a period of repair and are now resurging. I have little doubt that they will be market leaders again, but my guess -- just a guess, of course -- is that it's too easy now, and that another setback may be in the offing as it was for tech in 2008 before it led the current bull market.
9. Too much "dancing to the music" again: Just as Chuck Prince, then-CEO of Citigroup (C), helped mark the top of the last cycle with his (in)famous remark about having to dance while the music was playing, so MetLife (MET) may have helped define a similar problem with the current market darling, life insurance stocks. (They are plays on rising interest rates, among other things.) The New York Times recently reported on a difficult investigation that the State of New York made into life insurers. The state has apparently found that publicly-traded life insurers, but not private mutual life insurers, are engaging in activities such as self-reinsuring that may threaten the safety and stability of these companies. From Insurers Inflating Books, New York Regulator Says:
MetLife said in a statement Tuesday that it "holds more than sufficient reserves to pay claims on its policies" and added that it used reinsurance subsidiaries "as a cost-effective way of addressing overly conservative reserving requirements" for certain insurance products. If it had to set aside that level of reserves more conventionally, it said, it would either have to borrow - putting its credit rating at risk - or raise the money by selling stock, dragging its returns below the level its stockholders require.
Since when did life insurance become a go-go growth industry? Since when did shareholders of life insurers "require" anything other than prudence in running the business? I sold MET on the news. I'd rather it sell stock that it later can buy back if it turned out not to need the funds. Why take chances? You're a life insurer, correct? Widows and orphans stuff, literally. Be safe, not sorry. Will the stock march higher, though? The easy answer is sure, just so it "makes the numbers." Even if it's making them up.
This reminds me of the shenanigans that went on in housing finance that so many of us were basically unaware of in the last cycle. What "inning" is this insurance "issue" in? I have no idea, but it's disquieting.
Note this is not trivial stuff. From the opening paragraphs:
Insurers' use of the secretive transactions has become widespread, nearly doubling over the last five years. The deals now affect life insurance policies worth trillions of dollars, according to an analysis done for The New York Times by SNL Financial, a research and data firm.
These complex private deals allow the companies to describe themselves as richer and stronger than they otherwise could in their communications with regulators, stockholders, the ratings agencies and customers, who often rely on ratings to buy insurance.
10. Interest rates may be getting too hot or too cold, Goldilocks: Stocks have an arithmetical long-term valuation problem. The SPY has a dividend yield a little below 2.0%. This is about 30 basis points below the latest 10-year T-note rate. Since the financial crisis, the two yields have often been fairly close. Let us say that the 10-year T-note yields 4% two years from now. If Mr. Market merely wants a 3% yield from the SPY, it is hard to see how a bear market in prices can be avoided. Let's look out farther. Let us say that the 10-year T-note yields 6% twelve full years from now or sooner than that. Then let us say that as has been the rough average of the past hundred years, the market requires a dividend yield on the SPY that is equal to the yield on the 10-year note. If dividends increase at their historical rate around 6% per year, and the SPY were to yield 6% in 12 years, it would be trading right around where it is now. All one would have is the dividend. However, if the market required 6% from the SPY much sooner than 12 years from now, as was routine before the 1990s, the total return from now until that time might be very poor and even negative.
On the other hand, if interest rates were to drop sharply again anytime soon, that would open up the possibility of a deflationary, Japanese-style situation, and a stock crash might ensue.
Why stock prices should lead a charmed "life" year after year is unclear. Either rising rates or falling rates could break the spell. I'm simply less willing now to take much market risk given what I perceive as asymmetric risk-reward possibilities.
11. Analogy between stocks and recent broken manias: It seems as though an asset getting really popular and outperforming has carried a curse with it the last few years. First it was precious metals. After a full 29 years within its trading range, gold's price finally left its 1980 high around $875 behind in 2009. By 2011, it hit $1900. One poll showed that the American public thought that gold was a better investment than stocks or real estate. That was the top. Silver followed suit. Both have entered major, multi-year bear markets.
The next year was Apple Inc.'s (AAPL) turn. We all know what happened there. CNBC almost became an all AAPL, all the time show (so I am told, as I don't watch CNBC).
In both cases, precious metals and AAPL, the assets were good but got overpriced in view of record or near-record prices (silver) but deteriorating fundamentals. Something similar may be happening now with stocks. The media is bullish, advisers are bullish, margin debt is at a record level, supposedly P/Es are reasonable, etc. But, as I describe above, the actual sales and profits data are borderline recessionary. Supposedly a surge of growth awaits us in the second half of this year and next year. Maybe.
But if the economy surges, we could get into the situation where interest rates may normalize rapidly and stocks could sink anyway.
That sort of action would be similar to what happened in 1977-8, when stocks had serious bear market action despite no recession. That brings me to my final point.
12. There is an alternative (or two, or more): Taxable accounts can now purchase tax-exempt bonds at very competitive yields, perhaps 3% on A-rated munis of 10-year duration. After all, the average dividend yield one may expect to receive from the SPY over a 10-12 year period is about 3%, and that's taxable. And at that point, the SPY might be priced right where it is now -- or either higher or lower. Will it be higher? Who knows? You can be right on stock prices year after year, and then one 50% bear market can take years of price gains away, once again leaving you with nothing but dividends. Whereas with a bond, it matures and one gets to start fresh with the funds.
On the other end of the spectrum, American Express (AXP) runs an online, FDIC-insured savings bank that was paying 0.85% on demand deposits last I looked. I would anticipate that if interest rates have in fact entered a sustained uptrend, this rate will rise. Over time, this might be a simple and attractive hedge. One has perfect liquidity and can take advantage of whatever markets appear attractive at any time. So cash may not be trash under the circumstances.
Also, while it is not an interest of mine, emerging markets tend to boom and bust. Right now they are more in the bust phase but my personal experience with them is that if one is patient and buys them when they look scary, at some unpredictable point in the future they have provided attractive total returns.
Finally, as discussed above, when Treasuries have undergone the sort of sustained run-up in yields several years into an economic expansion that they have seen recently (and that is ongoing as of tonight), they have in recent decades been good contrarian buys. (Though for taxable accounts, munis have gotten even cheaper for buy-and-hold investors.) Commodities prices are plunging tonight (but once again that mean nothing by tomorrow morning!); if oil prices head south again, one may be looking at attractive real yields from long Treasuries once again.
Summary of the above: Actual data reported by the government and various market prices suggest that the rising P/E trend that has been in place since the SPY bottomed in early October, 2011, and that has intensified during the past year of a rising interest rate trend is at odds with the reported sharp deceleration in corporate sales and profits. In past cycles, such dramatic rises in rates have often coincided with market and interest rate peaks, even in the absence of recession.
Counter-arguments: There are too many to list. Prominent amongst them is the point that the Fed has been intervening at a record level in the bond market, so past patterns may be useless; plus the absolute levels of rates remain very low. Another is the "stocks for the very long-term" argument, with which I agree.
There are also individual names which I like and find reasonable buys in view of all the above facts, though in moderation given the challenged macro backdrop and maturity of the current business cycle.
My comments in this piece are focused on broad averages, not the several reasonably-valued strong companies that over time I expect to provide attractive returns.
Conclusion: I'll wrap up with one last graph. This is from the online polling organization ChangeWave. I received an emailed report from them today about general business prospects. Here is the relevant graph, which shows 29% of respondents saying that current sales have been below plan and only 20% saying sales have been above plan:
I report this because the relevant part of the title of this e-report to members is:
U.S. Economy Continues To Improve.
Heaven help us if this is improvement. We are now, allegedly, four years after the end of a recession. Yet the red line (below plan) has essentially never gone below the blue line (above plan).
If you have any doubt as to why Ben Bernanke and the Fed are continuing quantitative easing, please look no further. We have reached the stage where sensible people such as those at ChangeWave are reporting that a minimal, and I mean minimal, possible diminution in the rate of worsening is improvement. No matter that the range of statistical error is also consistent with mild economic worsening.
We all want things to get better, but facts are what they are.
I have no idea how much longer stock prices will diverge from apparent economic trends. Perhaps the economy will indeed surge strongly, interest rates will "behave," and current or even higher stock prices will look attractive. I'm no perma-bear. I simply believe that stocks are inherently risky, and so I do not want to pay full price for them based on hope for both upward acceleration of economic activity and interest rate stability.