Introduction: It has been a characteristic of this market cycle that some of the best assets have undergone major bull markets, then peaked and crashed even though the assets remained good assets.
In 2011, this happened first to silver, then to other metals, and then to gold and platinum, which peaked last, in August. From relative investment obscurity in America before Lehman collapsed, by August 2011 gold had become ultra-popular. The last few hundred dollars of the move came in direct response to the downgrades of Federal debt by rating agencies, then the unseemly wrangle over the debt ceiling. Gold then entered a bear market, rallied, then entered another bear market. Yet the fundamentals, such as they are for gold, did not change that much. The government kept adding debt, short-term rates stayed near zero and therefore below the rate of inflation, but gold stopped correlating with those parameters.
We all know the Apple (NASDAQ:AAPL) story.
One of the common threads behind the justification for ever higher prices of both gold and AAPL was that their traditional reasons for ownership were expanded, temporarily bringing in new buyers while the existing ones were not selling and might have been making new bullish investments as well.
Gold, in addition to its traditional role as an inflation hedge, it began to be promoted as a deflation hedge. The thinking was that if prices collapsed due to too much leverage in the system, then gold would lose value less than stocks, and that bonds would default, making them poor inflation hedges as well.
AAPL began to be promoted as an income and financial engineering vehicle along with a strong growth stock. This began when in March 2012, the board reinstituted a dividend and began its buyback program by sterilizing executive options grants. All of a sudden, everyone had a rationale for going long AAPL. Even though its valuation had increased by about $160 billion in 2 months simply because of one great quarter and a frenzied launch of the iPad 2, that was simply not enough for the crowd.
Stocks now are in a similar boat. They are for income, growth, inflation protection - you name it. Income stocks keyed off of record low interest rates, inflation protection stocks keyed off of the fact that interest rates were very low relative to inflation, growth stocks' P/E went to the moon for whatever reason you want to name.
Except for the implosion of mining stocks, this point is why the stock market does not feel as richly priced as measured by macro criteria.
Stocks are serving too many purposes, I believe. Just as the no-show of inflation or crisis in 2011 did gold's price in, and a business cycle peak did AAPL's trading price in, so may the profits trend for stocks plus rising interest rates finally take its effect on trading prices of public companies.
As in 1977, 1978, and briefly in 1987, this could occur in the absence of recession. Investors could simply change their minds about trading prices, just as they did for gold and AAPL
Background: I'd like to quote from a Seeking Alpha article published on June 24, 2013 titled Is It the Right Time to Lower Allocations to U.S. Stocks? I stated:
The two main theoretical supports of this bull market are both sliding rapidly out from under stocks...
When I don't like the odds, I seriously cut stock allocations and expect to be out of the market before the final top...
To switch analogies, there are a number of summer storm clouds gathering, and it may rain; if it rains it may storm. If it storms, first-quality equities may undergo an important (temporary, presumably) markdown. If so, cash today will not look like trash tomorrow.
It may be approaching a time for active asset allocators to decide whether to engage in any precautionary selling of U.S. equities.
For yours truly, a "better safe than sorry" attitude toward equities has supervened.
Today's stock market: The stock market has largely become leaderless. The leaders such as banks and insurers that make larger spreads when the yield curve lengthens have discounted that trend. What's left? Energy producers on the "hope" that Egyptian violence will lead to the Suez Canal being closed?
Now that interest rates have risen, electric utilities at 16-18X earnings or higher and Colgate-Palmolive (NYSE:CL) at 25X earnings have valuation challenges. At the same time, numerous large-cap growth stocks have seen earnings and/or sales decline yoy. Many of them are tech stocks, where this sort of thing is not supposed to occur outside of outright recessions. Yet overall, many such stocks have held up fairly well and many are well above where they were trading a year ago.
Numerous biotechs that lack approved products trade as exuberantly as they did in their frenzied year of 1991, which for biotechs was similar to the year techs had in 1999. And some small tech stocks doing well trade at stratospheric valuations.
There are some reasonably-valued strong companies, but no truly cheap ones. Even the resource companies that have collapsed recently are not cheap either on a assent or P/E basis.
Earnings quality is relatively poor due to widespread acceptance of non-GAAP earnings, "accretive" share buybacks, and the like. There has also been the nonsensical focus on "beating expectations." Years ago, CNBC gave up even presenting an earnings comparison with the year before, simply commenting on whether earnings met the latest analysts' consensus. Thus it was that in the Great Recession, only one quarter did not see at least 50% of stocks meet or beat consensus. Give analysts enough time and information, and by the time earnings are in the rearview mirror (i.e., get reported), they will indeed tend to come in "under" that earnings "beat."
Company after company is issuing either downbeat results or downbeat forecasts. This week, Deere (NYSE:DE) guided down, Macy's reported a sales decline after adjusting for CPI inflation and discussed challenges ahead, Kohl's (NYSE:KSS) guided down, and after-hours today, Nordstrom's (NYSE:JWN) reported a better-than-expected Q2 earnings report but guided down for the full year, an inauspicious trend. Add in Wal-Mart's downbeat Q2 report and full-year forecast, and the optimism for H2 profits that has kept stocks moving on up through a difficult earnings season is not being supported by the evolving evidence.
It is not good enough for those "bad" short-sellers to be pummeled, making highly-shorted stocks the market's leaders.
Valuation measures: Stocks at the recent peak had reached and perhaps exceeded their peak 2007 valuations. This can be seen in two ways. First, here's a chart combining a version of Tobin's q as well as the Shiller P/E. Per Andrew Smithers (see his commentary below the graph):
As at 6th June, 2013, with the S&P 500 at 1623, the overvaluation by the relevant measures was 63% for non-financials and 66% 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.
Smithers uses a non-parametric scale, so the recent peak in the SPY might have matched the 2007 peak.
Stocks have been at or above the Smithers "0" line for 24 years.
Meanwhile, hated and feared 10-year Treasuries below their long-term average around 4.1% for only a few years out of the last 50.
I'm going to feature the quantitative view of Jeremy Grantham of GMO. Mr. Grantham is famous for 10- or 7-year predictions of relative returns from different asset classes, based on the principle of reversion to the mean. Three charts from GMO show first, an idealized risk (volatility) versus prospective inflation-adjusted return, then GMO's estimates of valuations of different asset classes as of September 2007 and at the end of June this year.
The third graph is important because at the end of September, 2007, when I believe the data from this chart were created, the SPDR S&P 500 ETF (NYSEARCA:SPY) was at 153. It is now 166. Despite the Great Recession, the SPY, a proxy for U.S. large caps, has come close to providing the -2% annual real return GMO modeled. U.S. government bonds have indeed done better than stocks, as expected.
Exhibit 2, the second graph, shows that as of June 30, 2013, GMO's estimates of forward real returns for U.S. large and small caps was as dismal now as it was near the peak of the bull market in September 2007.
Furthermore, as a subscriber to GMO's free monthly update of these parameters, I can share their views as of July 31 (just released two days ago). Reflecting the rise in stock prices last month, U.S. large caps were projected to return -2.1% annually in real terms over 7 years, with an assumption that inflation mean-reverts to 2.2% over 15 years. U.S. small caps were projected to have a real return of -3.5% per annum.
As an exercise, I estimated what would happen under the above data if U.S. stocks mean-reverted to different valuation levels. All the data are 7-year annualized returns, but the "reset" assumes an instantaneous repricing of U.S. stocks downward to give higher projected returns.
GMO's valuation models give international large cap stocks a 4.5% annual total return advantage over U.S. stocks. (Even with that, their view is that international large caps are significantly overpriced relative to historical valuations that would give about a 6.1% return above inflation annually. (This is shown on GMO's monthly updates, not on the charts above.)
If U.S. large caps were to "reset" to give the modest positive 2.4% annual projected real 7-year appreciation that Grantham projects for int'l large caps, I estimate a 27% drop in the SPY. This is because GMO projects a negative 2.1% annual return below inflation for U.S. large caps.
If U.S. large caps were to reset to give their historical 6.1% real return annually for 7 years, I estimate a 46% decline in the SPY.
The numbers are worse for U.S. small caps versus international small caps using Grantham's numbers.
To match the prospective returns from int'l small caps estimated by Grantham to be 2.1% real, U.S. small caps would suffer a 32% drop by my calculations. To be repriced to yield a 6.1% real return annually for the next 7 years, U.S. small caps would, I find, need to drop 48%.
A. Unlike gold, which has mysterious influences on pricing, or a phenomenon unto itself (Apple), the stock market as a whole has had wide but somewhat explicable functioning over the decades.
Stock valuation has swung a full 180 degrees from the late 1940s, when despite selling well below asset value, high-grade stocks traded at perhaps 7X earnings and yielded 6-7%. Polls showed that the stock market was almost universally considered akin to speculating in commodity markets. Safe 2-3% bonds - that was what was prized. This was at a time when interest rates were, in the aggregate, similar to today. The fear then was of deflation and declining corporate profits. Today the fear is of inflation, and rising corporate profits are taken for granted, due to the presumption of growth with price inflation.
Today, safe 2% stocks are prized. And 3%-5% tax-free investment-grade municipal bonds are shunned. (Because "everyone knows" that dividends only rise, and rise rapidly?)
Are investors today making a major mistake in pricing stocks, opposite to the mistake they made in the late 1940s?
B. When I look at a stock, the first thing I look at is the balance sheet. EPS comes second. But no one talks about accumulated equity, unless it is to pump AAPL or one of the few other cash-rich popular stocks.
I wrote an article on Seeking Alpha Thursday about IBM. One of the reasons I gave for being negative on the stock was that it has a negative tangible book value. Thus all its value comes from future earnings. This is not a rare event any more amongst "safe" stocks.
Guess which one of the following companies does not have negative tangible book value?
It's CVS, with all of $2.7 B in tangible equity out of a book value of $38.9 B. Verizon has the greatest negative tangible book, at an amazing $71.9 B of negative tangible equity. These other icons all have negative tangible equity.
Of course, there are many legitimate, valuable assets that comprise intangibles and goodwill. Also, when companies acquire their stock above book value, book value takes a hit, even if the stock was reasonably judged undervalued when it was bought back.
Overall, my opinion is that too many companies I look at have thin equity and thinner tangible equity underpinning their valuation.
But earnings can be transient; equity is more resilient.
Despite this, it is reported that more stocks trading above 3X book than at the peak of the 1999-2000 bubble. This goes along with my thesis that the overvaluation of stocks is more difficult to see than it used to be, as all major types of stocks are richly priced.
Beyond the SPY, the Russell 2000 and the tracking fund iShares Russell 2000 ETF (NYSEARCA:IWM), have higher valuations than the SPY, slower growth, lower dividend yield, etc. This index, comprised of 2000 unrelated smaller stocks, has a price:earnings:growth (P:E:G) ratio that is similar to the NASDAQ's PEG in its bubble phase.
The "C" word?: I'm an investment nobody, but a somebody named Jim Cramer said today (Thursday), more succinctly than I did in my article quoted from above:
A "giant reset" is looming for the markets because the improving economy is simply not trickling down to companies' bottom lines, CNBC's Jim Cramer said Thursday.
Of course, "reset" means "crash" or something like that.
Jim Cramer is not the only one who is suddenly bearish. The money manager and economist, and previously bullish, David Kotok very recently came out with a very cautious note about the stock market to his clients. The technician Richard Arms notes a variety of bearish indicators, one of which is the failure of the VIX to move much on down days relative to the decline.
One reason to take seriously the chance of an air pocket a la 2011 or possibly worse is that it seems that virtually every bear has been converted to stock market bull. This list includes Lakshman Achuthan of ECRI, who actually suggested this year that a frenetic 1927-9-type rally may await us soon; Nouriel Roubini, who also this year flipped and forecast two more great stock market years; "Tyler Durden" of Zero Hedge; first Rich Bernstein and then his former Merrill Lynch colleague David Rosenberg; and, to an extent, Gary Shilling.
This phenomenon of conversion is widespread. A family member whose focus had always been on capital preservation opined this spring that she was quite OK with risk. In June, I received an email from an old friend that an old friend of his had come into an unexpected $20,000. He said that she had always been highly conservative with finances, and this friend, a former stockbroker, had urged her to be more aggressive with her money; but she had always refused. Now, 4+ years into a strong bull market, for the first time ever she wanted a hot tip. She may be Bernard Baruch's shoeshine boy, 21st century version.
The stock market never got to classic undervaluation in 2008-9. It is now reprising other patterns of market tops. As with gold two years ago and AAPL last year, the bull story is eroding away as interest rates rise and in August, retailers are lowering growth expectations for the rest of the year.
When, then, is the promised second-half earnings surge going to arrive?
The air is very thin.
It takes bulls to rush to protect their gains, fearing the bull run is over. It takes scared bulls to begin a fast bear move.
Numerous valuation and earnings trend reasons exist to suggest that trying to pick the truly undervalued stocks in a welter of richly valued to overvalued U.S. stocks is not worth a lot of effort. I own a small number that I think are high quality and undervalued, and hope their prices drop so I can put more money into them (and that nothing fundamental changes with them, of course).
As Cramer said Thursday and I said in June, cash may finally not be trash, at least for a while.
Addendum: I am submitting this on August 16. Financially, this is a fraught day and month. On August 13, 1979, Business Week ran its notorious "Death of Equities" cover. On August 6, 1979, Paul Volcker became Chairman of the Fed. In August 1982, the Volcker Fed energized the markets by engaging in three 1/2 point cuts to the discount rate and three cuts totaling 2 1/2-3% in the Fed funds target rate. The most dramatic of them occurred on August 16, a 1 point cut.
I received my first issue of Value Line in August 1979, and today my parents celebrate 65 years of marriage. My father, a long-time investor who never had a bank savings account until after retirement, started me on my stock trading "career" by passing on to me a small inheritance in the form of Diamond Shamrock stock on or around August 1979. I quickly gave a broker some business by exchanging it for three seemingly more interesting equities, and an avocation was born.
Thus I began investing precisely the month that Business Week announced that there were many headwinds for the stock market. I instead saw opportunity. Stocks were ignored and despised. Their annual total return for perhaps the prior 45 years had been in the 7% range, which seemed too low for all the inflation and growth that was going on. I saw opportunity in both stocks and bonds, depending on Fed policy in the next few years, stuck with stocks after August 16, 1982, only transitioning gradually to bonds in the late '90s.
Grantham, Smithers, Cramer, etc., aside, I personally see the opposite situation now.
I see the most famous market in the world (though not the most important), the U.S. stock market, overvalued and over-hyped, not at all the way it was in the 1979-82 period.
When a corporate raider tweets that he is long the most famous, well-studied company in the history of the universe, that he (with no tech expertise) has determined that Mr. Market is vastly undervaluing said corporation and that it should lever up more to give cash (which I thought was trash) to him, it's bad enough. When a headline promptly appears that Apple should put that corporate raider on its board, it is clear that it's silly season. AAPL has moved from the $400 range to about $500 in 2 years, on top of a moonshot preceding the move to $400.
That's not good enough?
This market has been picked over, and then picked over once more.
The Icahn-AAPL example of "unlocking value" might mark a similar top, just as the fraudulent "bid" for Dayton Hudson in the late '80s marked the top of the leveraged takeover craze of the day.
Again, it's one thing if this news appears regarding a trading sardine, but AAPL? Give me a break!
In early 1982, a Barron's poll of economists, I dimly seem to recall, showed that their favorite investment was cash. Stocks or bonds, not so much. After all, T-bills yielded at least as much as bonds with less risk. What they missed and young investor DoctoRx saw was that it was important to accept duration risk, given how undervalued long-term financial assets were by 1982, with inflation finally dropping rapidly.
But that was then. Stocks present much more duration risk now than the 10-year Treasury bond, from which investors are racing away in horror at receiving a "low" guaranteed return.
One of these days, U.S. stocks may finally get below Smithers' "0" line and once again be priced attractively as if they are risky assets.
If the Fed can lose control of the bond market, how can investors be certain of a "Fed put" forever for stocks?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: Not investment advice; I am not an investment adviser.