Understanding the Bear Case

| About: SPDR S&P (SPY)


In my last article I incorrectly called for the resumption of the bear market that ravaged stocks from late 2007 to early 2009. Despite a bevy of technical evidence I believed to be in my favor, the market apparently had other ideas, or as a friend and fellow trader put it, “even if you’re good, no one can tame the market.” Sentiment gauges such as the Investor’s Intelligence percentage of bears, and the 5 day moving average of the CBOE total put/call ratio reached levels not seen in years ( %bears had not been that low since 1987 in fact). Combine that with very overbought momentum indicators in equities, a steadily rising dollar, falling commodities and a sell off with extreme down side breadth that caused the Dow to breach its March-July low trend lines, and there was a very convincing setup for the start of another leg down. Then the market had one of those moments to remind you it will not be tamed. So going forward, before I offer my usual technical commentary on the market, I will start to preface these articles with some of the longer term fundamental reasons why I believe the correct course of action is to continue to look for topping and reversal setups in stocks.

Fundamental Valuation: Price to Earnings Ratio
The majority of media pundits and sell side analysts have once again declared stocks are cheap. However, money managers and financial advisors have been known to historically have a bullish bias (their compensation is derived from total assets under management). “Stocks are expensive, do not give me your money right now, there is not much I can do.” - Do you think money managers and financial advisors will ever actually say that? I think not. Furthermore, they are all touting extremely low and attractive price to earnings ratios. However the figures they advertise are forward estimates which are subject to sell side bias, bullishly skewed expectations, and not to mention clever accounting. When you look at what the S&P actually earned compared to current prices, a different picture emerges.

Chart 1: S&P PE Ratio -10 Year Smoothed – Inflation Adjusted

-Data courtesy of Robert Shiller and S&P, chart created by Multpl, edited by myself.

click to enlarge

In general, when the market trades at a multiple of less than 10, stocks are generally cheap. When the market trades at a multiple above 20, stocks are generally expensive. Not only are stocks not cheap, but they are well into the expensive range and above the level of the Black Monday 1987 crash. P/E ratios are often used (or misused) to value individual stocks, but I believe P/Es should be used more as a back drop to determine whether investors as a whole are over or under paying in relative historical terms. To be clear, by looking at the time scale on this chart you can probably tell this is not a shorter timing tool. P/E ratios could continue to rise to even more preposterous degrees (such as during the tech bubble), but this definitely not consistent with the view that stocks hit a long term generational bottom.

Fundamental Valuation: Dividends
In principle, dividends should be the foremost reason to purchase stock; a profitable company generates free cash flow, the stock holder – the owners of the company, should get a portion of the profits. Today, such a notion has been long forgotten and instead investing has become a hunt for short term capital gains. Looking at what the S&P 500 pays out in dividends, it is no wonder why. Prices of stocks have gotten so extended in the last several years that the dividend yield on the S&P 500 has become minuscule. When is the last time you saw a price target derived from the dividend discount model? Analysts have stopped using this method; sell side research shows a bias towards “buy” recommendations, and it would be difficult to justify buy recommendations using the dividend discount model because everything would appear overvalued. The following chart provides insight to where prices (and therefore yields) would be if the March 2009 low was of the “generational” proportion.

Chart 2: S&P Dividend Yield – 12 Month Periods - Smoothed

-Data courtesy of Robert Shiller and S&P, chart created by Multpl, edited by myself.

Observe how long term bottoms typically depress prices to the point where the yield reaches around six to seven percent. The “generational” low of 1933 presented an opportunity for investors to earn 12.5% per year in dividends alone. This begs the question, are prices today anywhere near those levels? No, if fact prices have pushed yields so low that they are below where they were during the 1929 and 1987 crashes. Stock holders are paid virtually nothing for the risk on owning stocks and instead are being compensated with mere hopes, dreams and promises dramatic future growth.

Mutual Fund Cash Levels (Potential Buying Power):
Pundits have been repeating the mantra that the enormous mountain of cash on the sidelines will be a source of buying power that will continue to drive the market higher.

Chart 3: Mutual Fund Cash Levels

-Chart prepared by Market Gauge

This looks less like a mountain and more like a mole hill. First, the level of cash at mutual funds is so low it is completely below the channel, and well into the bearish range. Second, this is the lowest reading ever except for the 2000 tech bubble market top and the 2007 credit bubble top. Third, is it any wonder that there has been no net progress in stocks for over a decade? There is little long term buying power in the aggregate market. These violent gyrations seem due to excessive liquidity and the ease at which larger speculators can quickly leverage momentum trades. Again, these are not short term triggers or timing tools, these simply provide a backdrop: right now is it generally smart to own stocks or is it generally dangerous to own stocks. All these indicators agree that stocks are very expensive, and at prerequisite levels at which steep declines can occur.

Monetary Conditions:
A Lawrence “Larry” Kudlow favorite; he loves to reference the upward sloping yield curve. First, I would mention that in 2007 when the yield curve was inverted, no one cared of its bearish implications. But now that the yield curve is upward sloping, suddenly its weighting in forecasting has become supreme. Granted, I do not have the impressive resume of a Mr. Kudlow, for example I was never dismissed from failed investment bank Lehman Brothers (OTC:LEHMQ) for abusing alcohol and cocaine, but regardless I would like to offer a different view on interest rates.

Chart 4: 30 Year Bond Yields

-Data provided by St. Louis Federal Reserve Bank, chart edited by myself.

Looking beyond the slope of the yield curve, long term interest rates have been falling for thirty years strait. The Fed has much less control over the long end of the curve than the short end, and now that the US credit rating is beginning to be called into question, it is a very real possibility that the curve is so steep simply because people are not willing to lend to the US in the long term. This view is backed by the precipitous withdrawal of indirect bidders in the most recent treasury auctions. Indirect bids are generally viewed as demand from foreign central banks; as this demand dries up, higher yields will be needed to entice buyers, forcing long term rates higher. This will in turn push mortgage rates higher in a already weak housing market. As long term lending gets more expensive, and investors can get higher yields for assuming the smaller (perceived) risk of investing US Government debt compared to the stock market; this creates a net negative environment for equities and economic growth.

Record Deficits:
The current melt up in the stock market and one “good” quarter of GDP growth are coming at the cost of a years of real economic growth in the future. With deficits at record highs and climbing, servicing this debt will become more and more challenging. This will eventually force the powers that be to cut spending and increase taxes, both of which are negatives for economic growth. Last year state governments took in about 87 billion less in taxes than the prior year, about an 11% drop and the largest decline ever. This is not a problem that will manifest itself years down the road, but has in fact already started. USA today reports that states are electing to hold onto tax refunds due to their huge budget short falls. Individual states have also begun raising taxes in more politically acceptable ways such as eliminating credits, exemptions, and broadening tax bases, but increases in individual and corporate rates are sure to follow.

Chart 5: Tax Receipts, Change in Billions

Higher taxes are almost a certainty, but there are likely to be a wide variety of negative effects. Spending in the form of pension benefits and government employment are likely to be slashed. Over the last several decades benefit payouts have ballooned as state governments assumed the tax revenues from the credit fueled boom were going to last forever. Furthermore, as the unemployment rate have surged to 10%, government employment has remained relatively stable. But now as states struggle with mounting deficits that they must close, government layoffs will soon most likely push the unemployment rate even higher. To summarize, the future holds higher taxes, higher unemployment, and far less favorable monetary conditions.

The Consumer is Not Coming Back:
As the US economy has transitioned from a industrious economy to an economy dependent on consumption, economic growth has become less dependent on production and more dependent on borrowing and spending.

Chart 6: Personal Savings Rate

As long term rates have dropped to record lows (chart 4), this has encouraged borrowing/spending and punishes financial discipline/saving, all the while inflation has reduced real wages. While the media pundits continue to promote low rates as a growth elixir, chart 6 illustrates the negative side effects. The average American has virtually no savings, with the savings rate near all time lows and hitting zero multiple times in the last decade. The savings rate actually went negative in 2005, at which point the government changed the definition of the savings rate so it would stay positive. Not quite the mountain of cash awaiting to push stocks higher and drive the economy.

The American consumer is more or less tapped out. Households have transitioned from needing one earner to households that require multiple earners and access to large amounts of credit. As savings are depleted and borrowing increases, consumers become leveraged and far less likely to withstand economic shocks. Chart 7 illustrates how strapped Americans have become, with nearly 20% of discretionary income going just to service their outstanding debt at the peak of the credit bubble in 2008. If 20% is going just to servicing debt (think minimum payment), imagine how large the outstanding debt must be.

Chart 7:

So in terms of savings, consumers have little to no savings to fuel future spending. Terms of credit, consumers are leveraged to the gills. We can see that future spending will be severely inhibited, and since consumption is more or less 70% of the US economy, growth going forward will far less than the exuberant expectations reflected in the stock market.

The Double Dip:
Government statistics always seem to come too late and reverse well into the trend of the economy. For example, the 4% annual growth in 2007 seemed to signal a strong economy, yet the country was teetering at the edge of a cliff. Then in early 2009, when we had a -6% annular rate of contraction, seemingly at the door step of oblivion, the economy suddenly and unexpectedly rebounded. So what does the current GDP reading of +5% tell us? Unfortunately, not much. Looking at a statistic that explains what happened 4 months ago and is subject to revisions months later is hardly what I would call a leading indicator. Instead I look towards the Consumer Metrics Institute’s Growth Index. The CMI measures the demand side of the economy by going as far up the sales chain as possible on a daily basis, even measuring sales that are still being processed. The idea being that consumption is such a large portion of the economy that directly measuring large ticket item spending in real time produces a much more timely, accurate, and sensitive result.

Chart 8: CMI Daily Growth Index

-Courtesy of the CMI, edited by myself

First, we can see in chart 8 that divergences typically occur at or near reversals; the CMI’s Growth Index is able to provide a much more timely warning than quarterly GDP. Second, we can see a huge divergence occurring in the demand side of the economy that GDP is currently failing to register. Third, the contraction as gone below the zero mark and unless it reverses soon, the double dip recession may have already started.

The Stock Market: Momentum
The melt up from the February 5th lows has pushed most momentum oscillators to their highest recorded readings since the March 2009 low. A reading of 70 on the Relative Strength Index or RSI is usually considered over bought: using daily periods, the Dow-Industrials made a high of 75 on the RSI, the Dow Transports 80.5, the Nasdaq-Composite 76, the Nasdaq-100 60, and the S&P-500 75, etc. On a weekly scale the S&P 500 is now above the recorded reading when it made its all time high in 2007.

Chart 9: SPX Weekly, 3 Years, with RSI

The Stock Market: Sentiment
One of the main reasons I thought the top was in back in January was the peak in many sentiment indicators, some of them hitting levels not seen in decades. Currently, many of the indicators are still at extreme highs and climbing with the melt up.

Chart 10: Investor’s Intelligence Percent Bears

-Data From Investor’s Intelligence, chart created by Market Harmonics, edited by myself.

Bears quickly came back into the market following the January – February selloff, only to be proven wrong (myself included). But we can see that we are still in the danger zone, with fewer than 20% respondents being bearish. Furthermore we are very close to the levels seen at the 2007 top and we recently hit levels not seen since right before the 1987 crash.

Recently the New York Times ran a story that day trading is once again back in vogue. Historically that is not a good sign for the stock market: a phenomenon that typically occurs near tops as new and unskilled traders enter the market in hopes of making a quick buck.

Chart 11:

Looking at the commitment of traders reports for the S&P E-mini contract, we can see that the small speculators are back (just in time to get wiped out all over again). I created this chart by summing the long and short positions for both the large and small speculators to arrive at their cumulative net long (or short) positions. Small speculators have been mostly short for over a year, but you can see the absolute surge in small speculative positions starting in January, and they are now net long. Furthermore, you can see that large professional speculators have actually been selling to the weaker hands especially the last few weeks as the market has hit new recovery highs. To summarize, the dumb money is now buying, the smart money is now going selling, behavior that is consistent with a top being formed.

Option players have gotten wildly bullish too it seems, especially options on individual equities. While trading volumes in stocks have been consistently falling, equity options volume are back at record levels. Another sign of a wildly speculative market and the kind of behavior one would expect to see at a top.

Chart 12: 5 Day Simple Moving Average, Equity Put to Call Ratio vs S&P

-Created by Index Indicators, edited by myself

In closing, why do I continue to be bearish? Long term fundamental valuations show that stocks are historically expensive by a variety of valuation metrics. Our economy has been subsisted on a consumer that must borrow and spend, rather than innovation and production. The only innovations have been in the “how to make consumers spend more money” department. However, savings and credit have been exhausted so future spending will be muted. The CMI’s daily growth index shows a severe contraction in the demand side of the economy while businesses build out inventories that will most likely go unsold. The double dip may have already started, meanwhile the small speculative investor is only now getting back into the game after a +50% retracement… and they wonder why they think the game is rigged. They rig it against themselves.

Disclosure: Long SPY puts