Due for a Correction? Market Is Already Priced for Grim Future

The S&P 500 is up 50% from its low on March 9th of this year. I detect a wave of sentiment that says it's time for a correction, that prices may have gone too far, too fast, that the news isn't good enough to support such high prices. But as I said in an earlier post, the market is not exactly priced to good news or even to a recovery. I showed a chart of credit spreads to illustrate my point: credit spreads are still higher than they were at the peak of the 2002 financial crisis, which at the time was the worst period for corporate bonds since the Depression. If the market is still priced to a rather grim future, I question whether or why a significant correction is in order.

The first chart makes the same case but from a different perspective. It shows Bloomberg's Financial Conditions Index, which is "the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period." Financial conditions are still about one standard deviation below the levels that might correspond to "average." They are today about the same as they were during the 2001 recession and the 2002 corporate bond market collapse. In other words, current financial conditions are still far below what might be called "healthy."

The second chart shows the history of 10-year Treasury yields. Currently at 3.42%, 10-year Treasuries are still at very low levels from an historical perspective. They've only been lower during periods of deflation and/or depression. Given the Fed's incredibly expansive policy actions, buying Treasury bonds at today's yield levels only makes sense if you think the economy is incapable of mounting a meaningful recovery, while the risk of another (or an extended) recession remains high. (I don't share this view of course.) In short, this rally has not been driven by optimism, but rather by a reduction of pessimism. The market was priced to Armageddon in March, and now it's priced to a recession.

My thesis since November of last year has been basically unchanged: I have thought that the market was overly pessimistic about the economy's future, and valuations were therefore very attractive. I have seen numerous signs, beginning last October, that leading financial market indicators, such as swap spreads, were pointing to improvement, yet the market was priced to continuing disaster. The encouraging signs I began to identify in October and November turned into "green shoots" that are now appearing almost everywhere: declining credit spreads, declining implied volatility, rising commodity prices, rising shipping rates, rising confidence, rising home sales, a bottoming in residential construction, improving manufacturing conditions, rising capital spending, declining unemployment claims, etc.

Like the market, I was blindsided by the dreadful selloff that occurred from mid-February to through early March. I think that selling climax was the market's way of expressing its horror at the degree to which fiscal policies had suddenly shifted to the left: a massive increase in so-called "stimulus spending" threatened a similarly massive increase in future tax burdens, not to mention a gargantuan increase in the public debt.

Since then, my thesis has reasserted itself. From the vantage point of politics, the rally has been driven by a lessening of the horror of big government, and that in turn has been largely a function of Obama's policy prescriptions being rejected by the electorate and bogged down in Congress. Things are not turning out as badly as the market once thought. That's not to say that the future looks bright, simply that the future looks less ugly.

So my thesis is still this: the outlook for the economy that is implied by current market pricing (e.g., the level of Treasury yields, implied volatility, credit spreads and P/E ratios) appears to me to be worse than what the economy seems likely to deliver. I think we're in a recovery, but the recovery is going to be sub-par; we are likely to see growth of 3-4% per year for the next several years, but this will not be enough to get the economy back on the track that it was on for the past few decades. It's going to feel like a jobless recovery, a tepid recovery, and a frustrating recovery, but it will still be a recovery. The market expects a lot less than that, however, so it still pays to be optimistic.

This chart shows the implied volatility in bond and stock options. Note that volatility has dropped significantly from the highs of late last year, but it still remains at elevated levels from an historical perspective. I take this to mean that the market is still very nervous about the future, which is another way of saying that the market's outlook for the economy is far from clear. That's why you see lots of talk these days about a W-shaped (double-dip recession) recovery, or an L-shaped (no recovery) recovery. My point is that this market is not priced to optimism, and is still plagued by lots of doubts and fears. If the economy can mount even a modest recovery, as it appears to be doing, then it will pay to be optimistic.

Comments

[Clone Reagan:]

Something new to the mix: In 2010, lacking any strong recovery stats which is the greatest likelihood, the Obamaites are going to get trounced in the mid-terms, and the howls for reduction in government outlays before and after that event will buoy domestic and overseas markets -- since reducing the federal load is about the last trick in the backpack. If Obama was smart (jury still out, perhaps drunk) he would pivot 180 degrees, renounce all health care scamming short of a small kid care package, and then put a moratorium on non-DOD hiring, and in fact seek RIFs throughout the bureacracy. Reagan did this, and it was vital to changing the national mood and our long term federal spending (even though in took Newt and the GOP majority in the 90's to actually get the books straight for awhile). We know the cure. The need is for putting an end to Obamanomics, and bringing back some sense of fiscal restraint at the federal, state, and local level -- none of which has happened to date, outside of Calistan.

Sep 02 01:48 PM

[bobbybutte:]

Yes the fact that many large cap multinationals are inexpensive

as long 10 year t bils are under3.4% any sell off will be temporary
Maybe we will be down to 890 but that about it

by year end we will be around 1100 on the S&P.

Sep 02 01:53 PM

[ebworthen:]

Regardles sof healthcare or cap and tax bills getting through Congress - all taxes will go up.

Look for much higher tax rates on capital gains, estate taxes, death taxes, etc.

The trillions in deficit, which is now $9 trillion (that is nine thousand billion dollars), must be paid for via taxation and inflation; our politicians won't stop spending.

It's possible the stock markets will do a V, then a W, or a L; however, the real market, the economy, will sooner or later dictate true direction and it won't be up for a very long time.

Sep 02 02:43 PM

[buybigtires:]

Ebworthen hits the nail on the head: They are going to have to make up for declining revenues and increased spending somehow. The market is like an angry dog on a chain: It can only go so far before reality constrains it.

Sep 02 03:06 PM

[Starman:]

Go to Hell ALL you "gloom and doom" mental midgets!!!!

Sep 02 03:23 PM

[jay brebner:]

starman - I agree. great first comment. way to pop that cherry. like the use of !!!s.

seriously - the author's view is entirely plausible. the reaction to selling this week has not been panic - yet. The Bloomberg chart showing the march low to be an 8sigma event shows it well. The world economy is getting organized around the energy efficiency theme IMO. Once it starts moving forward in unison it will be a powerful force that will lift many boats.

Sep 02 04:16 PM

[Shonkypom:]

Most contibutors are valuing the whole market as if to invest is to own the whole of an index. Instead, pick those companies that have a genuine economic reason for existing, a solid and loyal client base, non-cyclical and non-commodity markets, many years track record of sustainable earnings stability, a durable competitive advantage, a high return on equity and assets, a high percentage of management ownership, experienced and talented management, low debt and a low requirement for borrowings, high cashflow, and good ethics. You will find that it doesn't matter what the market does, those companies will continue to perform and will be able to adjust their pricing and costs to market conditions - you will be very comfortable with the return on your investment as a result. But that takes a lot of time and effort to research...much easier to run with the herd...right?

Sep 02 05:02 PM

[mark joseph:]

No doubt you (author) were part of the throngs that were "blindsided by the dreadful sell off". "those who forget history bound to repeat it"

I am more interested in hearing from those who were not "blind sided" and predicted this in detail years before it happened.

Like a few others Warren Brussee predicted in his book "the next great depression" (in 2003) that this would be happening. Mr. Brussee predicted virtually to the month. He is an unemotional mathematician. He draws a simple comparison that my 9 year old could follow.

Let’s compare the Great Depression stock market drop to what is going on now.

INITIAL MARKET DROPS
From September 1929 to October 1929, the market dropped 48%.
From October 2007 to March 2009, the market dropped 56%.
So the drop percentage was pretty close, but the recent drop took longer.

DEAD CAT BOUNCE
From October 1929 to April 1930, the market jumped 48%.
From March 2009 to July 2009, the market jumped 48%.

FINAL DROP
From April 1930 to July 1932, the market dropped 86%.
From July 2009 to 2012, the market will drop ??????

So the current dead-cat bounce is identical to what was experienced early in The Great Depression.

How can anyone just pollyanically gloss over this stuff just because they need to find a happy place?

Sep 02 05:23 PM

[LeoTheDog:]

"the rally has been driven by a lessening of the horror of big government, and that in turn has been largely a function of Obama's policy prescriptions being rejected by the electorate and bogged down in Congress."

Really, is THAT what has driven the rally?

Sep 02 06:04 PM

[User 357705:]

My thesis was and remains that there are some seriously thick dark rose colored glasses in them there OC hills!

Sep 02 06:16 PM

[jay brebner:]

mark joseph - you can't speak to people's motivations for seeing things differently than you. The gov response to 1929 was completely opposite to 2009. That is the difference and it is not polyannish to expect a different outcome. It may be wrong but my outlook has come from taking a pulse of the econ by my own method. Others have surely done so as well and come come to their own conclusion. And may I add that being a bull now given the emotional scars of what has happened recently is not a happy place feeling as it goes against what I would like to see happen = total destruction of wall street and all those who were complicit.

Sep 02 07:01 PM

[Vuke:]

A very good forecast Pundit. There will be a long and arduous recovery, built on the back of a sacrificial USD, the only currency the rest of the world uses to convert their printing press products into needed oil. The new order that emerges will be interesting as India, China, Brazil etc. expand their economies, often at the expense of US exports.

But, as the dollar declines U.S. manufacturing will become more competitive so, at some level the ultra-efficient U.S. economy will revive its lead once again. Of this I am confidant having lived and worked in a few others.

Pain will be felt by savers but this can be minimized by investment in gold bullion or good gold producers as there'll be no collapse in gold. It is being carefully managed and, when the time comes to convert, the remainder of the world, now becoming addicted to the printing press, will be happy to buy.

Sep 03 01:02 AM

[Anthony Alfidi:]

"If the economy" can do this or that even modestly is a very big IF given consumer retrenchment and debt overhang in every conceivable sector. The market is fairly priced only if you define a grim future by 2002 standards. A more appropriate reference point would be 1932.

Sep 03 08:35 AM

[manuel:]

SorrY can you explain me how you measure the correlation between gdp growth rate and market price? Why is the S&P pricing in 4% growth? Such high P/E multiples are pricing a higher growth it seems to me a least, do you have an answer. Should I look at earnings growth or gdp growth? So even if earnings do not grow much but gdp grows 4% the market would be fairly priced and not overvalued?


On Sep 01 11:33 AM Mad Hedge Fund Trader wrote:

> tri. US stocks are now the most expensive they have been in seven
> years, and never really got cheap during the March low, just fairly
> valued. At least I have some good company in my views, which are
> also shared by David Rosenberg of Gluskin Sheff, the former chief
> equity strategist at the late Merrill Lynch. The “faith based” rally
> is now discounting a GDP growth rate of 4.0%, which has a snowball’s
> chance in Hell of actually occurring. This is up dramatically from
> the 2.5% growth rate the S&P 500 was discounting when the index
> was at 667. The best stock market rally since 1933 added an unprecedented
> eight PE multiple points to stocks, and there is now more risk in
> the market than the 2007 peak. Underweight portfolio managers and
> momentum driven day traders are to blame. It’s what happened after
> the 1933 rally that scares me. Needless to say, stocks offer no value
> here. You can sign up for David’s well thought out research for free
> by going to his website at www.gluskinsheff.com/.

Sep 03 09:01 AM

[manuel:]

Would the 4% GDP growth have such an impact on earnings that P/E would look fairly valued?

Has anyone have an answer?

Sep 03 09:04 AM

[manuel:]

If the P/E on trailing earnings is around 100 now, and earnings would double next year with a high gdp growth, that would leave us with 50 P/E, still high, so it seems overvalued

Sep 03 09:09 AM

[TATyszka:]

On Aug 31 07:08 PM Bjarne Jensen wrote:

> Nick, when i go to your link it shows a P/E of 18?

Bjarne, I followed the link, then clicked on Index Level Fundamentals; it shows this:


S&P 500 Index Level Fundamentals
Ratio 1Q 2009 2008 2007
PE 116.205 60.688 22.190

Sep 03 09:10 AM

[TATyszka:]

Let me clean that up a bit:

P/E Q1 2009 116
P/E Q1 2008 60
P/E Q1 2007 22


On Sep 03 09:10 AM TATyszka wrote:

> On Aug 31 07:08 PM Bjarne Jensen wrote:

Sep 03 09:11 AM

[ebworthen:]

The market is not already priced for a grim future.

The market is priced for Stimulus II, accounting tricks, free money to the banks to hold or lend at 5-25% while increasing fees and firing seasoned employees, a jiggered money supply, and false hope.

If I was given interest free money, could claim my debt as an asset, stiop paying my kids allowance, and had a $100 printing press in my basement my neighbors would think I was doing really well; even though they never see me leave the house to go to work.

Hmmmm...

Sep 03 10:10 AM

[manuel:]

if the Market goes down, everyone goes down, good and not


On Sep 02 05:02 PM Shonkypom wrote:

> Most contibutors are valuing the whole market as if to invest is
> to own the whole of an index. Instead, pick those companies that
> have a genuine economic reason for existing, a solid and loyal client
> base, non-cyclical and non-commodity markets, many years track record
> of sustainable earnings stability, a durable competitive advantage,
> a high return on equity and assets, a high percentage of management
> ownership, experienced and talented management, low debt and a low
> requirement for borrowings, high cashflow, and good ethics. You will
> find that it doesn't matter what the market does, those companies
> will continue to perform and will be able to adjust their pricing
> and costs to market conditions - you will be very comfortable with
> the return on your investment as a result. But that takes a lot of
> time and effort to research...much easier to run with the herd...right?

Sep 03 02:03 PM