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Hedge fund manager, growth at reasonable price, medium-term horizon, contrarian
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In the past few days I have read numerous articles using flawed and contradictory methodologies, which discuss a looming 1987 style crash and a U.S. Stock Market Bubble among other predictions. While I don't think U.S. large cap equities are a great proposition in absolute terms (I much prefer physical asset investing), they are certainly the "tallest midget in the room," are absolutely not a bubble, and I respectfully disagree that we will see a crash or even a bear market in the near future for very simple reasons.

Reason 1

Borrowing rates are still far below corporate cash flow yields. In simplistic terms, the spread between what companies earn and investment grade bond yields are still simply out of whack. Companies of today are far less leveraged than companies of yester-year and corporate managers are far more tight-fisted with their capex. Below is one way of looking at the excess returns from stocks vs. bonds.


(Click to enlarge)

Source: Bloomberg

For stock valuations, I use my preferred measure, EV:EBIT, which takes into account the entire capital structure as well as capital intensity. Many perma-bears, whom I won't refer to by name, like to talk about PE10, "secular vs. cyclical", Gold:Dow ratio, and other measures which are sexy, but not really helpful in the real world. If you want PE10, you'll have never owned a gorilla like Priceline (PCLN), or participated in the bull market from 2003-2007, and you'd have been chasing Euro stocks all the way down. Yes ... Interest rates and free cash flows do matter!

At a high level, the situation we have today cannot continue to exist for the long-term. Either bond yields need to rise massively or the stock market needs to go ape (fill in the explicative). Alternatively, both can occur in "Goldilocks" fashion until high borrowing costs begin to meaningfully affect economic growth thereby making bonds appealing investments with capital appreciation potential.

Reason 2

Credit spreads are remarkably strong for now. Despite clear deterioration in the emerging markets, U.S. high yield has been remarkably resilient. Spreads on high yield debt are below their historical median, and unlike 2011 aren't signaling some sort of dangerous slowdown and deflationary debt liquidation. A spike in credit spreads is an absolutely necessary indicator for a market crash to occur. We may be seeing it in emerging markets debt (even that's been relatively tame), but we're definitely not seeing it yet in the U.S.


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Source: BAML

Reason 3

This view on credit spreads is corroborated by figures like homebuilder sentiment, industrial production, and capital expenditures, which are encapsulated in a handy little statistic called the leading economic indicators. I'd like to see LEI go below zero before sounding the alarm bell. It really looked like it was going to happen last year until Europe got its act together, but as of today there is no evidence of economic deterioration.


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Source: Conference Board

Reason 4

One major strike against any sort of crash in any risky assets, including Emerging Markets, is the remarkable containment in oil prices. A spike in oil has been a factor in almost every major bond market/stock market crash event I can think of: 1974, 1982, 1987, 1990, 2000, 2008 and 2011. We're nowhere close today.


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Source: Stockcharts

Conclusion

Given current macroeconomic conditions, I think it's unlikely we see a stock market crash in 2013. The environment today is vastly different than what we have seen in past crashes.

  • Stock valuations are tame
  • Appetite for risky debt remains strong
  • Economic growth is slow but solid
  • Energy prices are contained

Thus, any sort of correction should be used to buy your favorite companies at a discount.

At the same time, it's always good to know the risks. There are potential headwinds coming out of Emerging Markets. Continued rising borrowing costs will pressure cyclically oriented companies. Thus, I think investors need to focus on growth, which the investment community at large is willing to pay a premium for in muddle through environments. While the S&P500 made took out its 2011 highs in early 2012, the Russell Small Cap growth ETF, IWO, only broke out from that steep drawdown in early 2013. In other words, this party may have just started.

Source: I Respectfully Disagree, No 1987 Crash In U.S. Equities