- As we enter the sixth year of this bull market, the Russell 2000 is trading at 83X estimated 2014 earnings, which is insane at this point in the economic cycle.
- Federal Reserve's $4.25 trillion balance sheet and zero Fed funds rates have artificially inflated high-beta, small capitalization stocks like the Russell 2000.
- I'll share with the reader my list of ten fears that could knock down the Russell 2000 index.
Let's look at how far the market has bounced off the early March 2009 stock market bottom.
iShares Russell 2000 (NYSEARCA:IWM):
- March 9, 2009 intraday low, $34.26, and adjusted for dividends, $31.94
- March 21, 2014 closing price, $118.61 (up 271% off the low)
- Trading at 83X estimated 2014 earnings
PowerShares QQQ (NASDAQ:QQQ):
- March 9, 2009 intraday low, $25.74, and adjusted for dividends, $24.37
- March 21, 2014 closing price, $89 (up 365% off the bottom)
- Trading at 22X estimated 2014 earnings
SPDR S&P 500 (NYSEARCA:SPY):
- March 9, 2009 intraday low, $67.1, and adjusted for dividends, $61.38
- March 21, 2014 closing price, $186.2 (up 303% off the low)
- Trading at 18X estimated 2014 earnings
Total Market Capitalization of S&P 500 companies as of 2/28/2014 - $17.7 trillion (yikes!)
2013 U.S. GDP: 17.080 trillion
At the outset, I fully acknowledge that it's a fool's errand trying to predict, especially with any precision, the top of the stock market, and notably, the Russell 2000 index of small capitalization stocks. It's hard enough trying to discover undervalued individual securities, never mind trying to synthesize immense amounts of information to determine fair value of the Russell 2000. From this grounded and objective starting point out, I will share my ten fears to the Seeking Alpha community. If I'm wrong, people can go back and laugh at me in six months' time. In fact, I fully expect strong negative visceral responses from starry-eyed bulls, who have been viewing the market through the lens of Willy Wonka-branded rose-colored glasses. These bulls have been basking in the afterglow of last year's major leg-up and are exhibiting the swagger that the market can't decline, and therefore, has been reflectively buying every dip. Generally speaking, this buy the dips strategy, including buying the Russell 2000 on any weakness, has been highly lucrative, with the Russell 2000 climbing the proverbial wall of worry on its upward and unrelenting march higher.
However, as I recall, no one rings a bell at the top, and it's unknowable when the markets will suddenly pivot and change direction from the weight of its overvaluation as the market did on October 19, 1987, when the Dow Jones Index plunged 22.6% in one trading day. The Russell 2000 seems invincible until it isn't. Despite the severe losses suffered during the 2008-2009 market crash, arguably disproportionately negatively impacting retail investors, who sold near the bottom out of fear, this is my public service announcement to reduce your risk profile and sell your shares in the Russell 2000 index. I would even argue it may be prudent to hedge your portfolio against a correction to allocate a small portion of your portfolio in ProShares Short Russell 2000, which is an ETF that tracks the mirror opposite of the Russell 2000's daily performance.
With these provocative opening statements out of the way, let's launch into my top ten list of fears:
- This is a Federal Reserve and Quantitative Easing (QE3)-induced rally
- Russell 2000 valuations are at nosebleed highs, adjusted for the record U.S. corporate profit margins
- The U.S. has been running unsustainable massive fiscal deficits
- There has been record corporate debt issuance earmarked for huge equity buyback programs
- The middle class is on struggle street, exhibited by declining real median incomes, which will eventually hurt aggregate demand
- Low population growth, record student loan debt, and very high under- and unemployment measured by the more encompassing U6 index are and should continue to hurt first-time housing formations
- Unfavorable demographics and lack of savings may hurt baby boomers' consumption patterns
- The BRIC's GDP has slowed dramatically
- NYSE margin debt near record highs, and signs of irrational exuberance in the IPO market
- Under-funded pension liabilities of states and local municipalities
I could keep going, but I'll stop at ten, as this list starts to become a variation on the same theme. Also, I'm not even going to touch the lightning rod that is ObamaCare, as it's too soon to know its outcome.
Fear #1 (The Fed and QE)
As of March 19, 2014, the Federal Reserve's balance sheet now stands at $4.26 trillion, up from $915 billion on December 31, 2007. This is unprecedented in the Federal Reserve's one-hundred year history. Investors have been spoiled and forgot how unusual this policy is compared to the Federal Reserve's history.
Moreover, the Federal Funds rate has been held at less than 25 basis points since December 2008. This extremely accommodative policy matters, because it directly artificially drives down mortgages and interest rates. Additionally, the Federal Reserve's buying power removes over $3 trillion in fixed income securities-enabled financial institutions to profit from front running the Fed's purchases of agency securities and treasuries. Bond prices are inflated, removing this amount of securities from the public float. Also, Quantitative Easing, referred to as QE, as a policy, was arguably another stealth bailout of financial institutions. Furthermore, with the Fed Funds at less than 25 basis points, market participants starved for yield have been forced to extend out on the risk frontier to generate income. Please note, reaching for yield has created a new pool of buyers forced to purchase real estate, dividend stocks, and high-beta stocks like the Russell 2000 index in hopes to generate income in an anemic yield environment.
Either way, besides the first round of QE, which was arguably heroic, as it most likely saved the system, QE2 and QE3 were, in my opinion, wealth transfers from the American general public to the super wealthy, Wall Street, and large financial institutions. This article by a former QE manager, Andrew Huszar, captures quite poignantly his moral objections by resigning.
For a high-level reminder of how we got here, below is a summary. If readers are fully versed on this topic, then skip to the Fear #2, as this section is optional reading and could be considered superfluous.
(Optional reading section)
The Federal Reserve finally figured out that U.S. financial system was on the brink of collapse, driven by obscene amounts of (supposedly) highly-rated AAA synthetic mortgage debt, derivatives and exotic financial instruments, significant off-balance sheet shadow lending, and a fundamental imbalance, where investment banks owned longer-dated assets financed with short-term and callable funding (repos and commercial paper) that dried up when the market lost confidence in the investment bank's risk management. Even worse, at peak levels, Bear Stearns and Lehman Brothers were operating with upwards of 30X leverage for short periods of time. I'll quickly remind the reader of the simple math what happens at 30x leverage, and too large a reliance on short-term funding: if the investment bank's assets decline by 4%, they overnight they become technically insolvent, not to mention that during period of market turmoil, buyers of hard-to-value securities dry up and illiquidity takes hold, leading to cascading prices. However, before I get too deep into the weeds reanalyzing the financial crisis, the thrust of this article is not about rehashing the financial crisis, as there are countless excellent books written on this subject. However, given the extreme nature of the Fed's crisis response, I think it's important to recap this history for readers not as familiar with what transpired.
Fortunately, at least in the popular opinion polls of most, Ben Bernanke was a student of the Great Depression, and once he figured out how dangerous the situation was, he acted swiftly, boldly, and perhaps, cleverly (depending on your perspective), suspending FASB 157 to save the banks from insolvency (the requirement that financial assets need to be mark-to-market through third-party price discovery, and labeled different levels (level I - level III) independent price discovery in a transparent market. However, besides the initial QE1, which has broad academic support from leading economists and even folks at venerable Stanford University, like John Taylor, the jury is still out as to whether QE2 and QE3 was good policy.
I would argue QE2 and QE3 were and are misguided policies that disproportionately benefited the top few percent, which own the lion's share of financial assets. I'm also not going to get into carried interest, another lightning rod topic. With the cover of low nominal and real inflation given the slack in the labor markets, the biggest driver of inflation for most industries, the Fed has quite possibly created one of the largest wealth transfers from the middle class to the elites. In fact, the policy of helping America get back to work through QE2 and QE3 has been disproven by Stanford Ph.D. and mutual fund manager, John Hussman, who manages Hussman Funds. Mr. Hussman has methodically documented in his research, with persuasive and empirical evidence, that the Fed's QE2 and QE3 have not created the heralded and projected number of jobs, as advertised or promised. Given this policy failure from the perspective of helping the prosperity of broader Main Street economy is so disheartening, and undoubtedly, there very well might be unknowable unintended consequences that the society may have to deal because Fed took QE too far the second and third time. With a balance sheet north of $4 trillion, unfortunately, the Fed can't put this genie back in the bottle without some form of unintended consequences.
Blinded by rising stock prices, bullish investors in indices like the Russell 2000 have decided to look the other way, as they are making money, so why question if the policy is sound and in the best longer-term interest of the entire country? I have no idea how this ends or what occurs when the Fed's punch bowl is removed, but I do know that signs of irrational exuberance abound.
Fears #2 & #3 (Valuations, corporate profit margins and fiscal deficits)
Not only is the PE ratio of the Russell 2000 outrageous measured against history, it's especially elevated five years deep into a bull market, which would by definition mean earnings are closer to peak than trough, so the "E" in earnings isn't distorted by a recession. What's even more alarming is that not only is the Russell 2000 trading a 83X estimated 2014 earnings, this is a very rich multiple for this point in the cycle. I would argue investors should pay no more than 18X earnings for what might be peak or at least a plateau in 2014 profits, at this point in the cycle. Expanding upon this topic, corporate profits are inflated by record after-tax corporate profit margins. As we can see from this chart below from John Hussman, historically, after-tax corporate profit margins have averaged 6%, they now stand at 10%.
Source: This chart is from John Hussman's 12/16/2013 Weekly Commentary.
This record of after-tax profit margins is driven by a few major factors:
a) The extremely high unemployment, measured by the U6 index, and the fact that actual unemployment under represents true unemployment, as discouraged workers have dropped out of the labor pool, measured by labor force participation near a thirty-five year low. However, the pendulum will swing back eventually as the era of "doing more with less" and "just be happy to have a job" shifts to competitors paying up for talent by trying to pick off trained and experienced workers with the enticements of more pay or better benefits. This dynamic shift will eventually occur, as 10% after-tax profit margins, up from 6%, are probably three standard deviations above the historical norm. If or when they revert back because of market forces, this in and of itself could cause a 40% drop in profitability.
The other dynamic enabling corporate profits to be so high despite a cautious U.S. consumer is that the U.S. government has run massive fiscal deficits starting at the end of the Bush presidency and expanded sharply during the Obama Administration. U.S. government debt now stands at north of $17 trillion, but don't tell Dick Cheney, because to him, "deficits don't matter".
So over the past five years, corporations have enjoyed many tailwinds, notably artificially lower labor costs, with labor representing one of largest inputs for many sectors of the U.S. economy (notwithstanding select hot sectors), as well as unprecedented government spending to maintain aggregate demand. GDP is calculated as C (consumer spending) + I (Investment: mostly business investment) + G (government spending), plus the net of imports and exports. Well, let's just say, the G in this equation has helped offset a lot of the consumer deleveraging.
So, again, it's no wonder why corporate after tax profit margins are so much higher this cycle, as the combination of stable aggregate demand from running deficits, lower input costs for workers, access to cheap debt to buy back stock are great for short-term stock prices.
Fear #4 (record corporate debt issuance and stock buybacks)
According to the Basel Bank of International Settlements, as of June 2013, global total debt now stands at $100 trillion, which is up sharply from $70 trillion in mid-year 2007, as governments have borrowed to fuel declining consumption, and bloated bank balance sheets lack the capacity to expand, leading to this demand being filled through the creation of fixed income securities instead of bank loans. Interestingly, the stock of public debt securities reached $43 trillion in June 2013, up 80% from mid-year 2007.
Despite a down year for bonds, measured by the total return of approximately negative 1.8% for the Barclay's Aggregate index (and even worse for longer-duration fixed income treasuries), there was record investment-grade issuance of $1.11 trillion in 2013.
The strong demand for yield has enabled highly-rated companies to issue record amounts of debt over the past two years. This appetite for yields isn't restricted to investment-grade bonds, as there was also record issuance for junk bonds, which greatly helped marginally profitable companies within the Russell 2000 index, which for the first time, had access to issue bonds at some of the lowest yields in history. This money can and has been recycled back through movement into supporting stock prices (please note - generally speaking - executive bonuses are often directly tied to stock price performance, as they get paid in stock options and/or bonuses are paid based on the performance of the company's stock price). So although this record debt issuance and stock buyback help stock prices in the short term, upper management has resorted to this strategy to mask the lackluster top line revenue growth.
As this WSJ article points out, in the third quarter of 2013, including buybacks of $128 billion and dividends of $79 billion, companies have returned $201 billion to shareholders, the highest rate since the fourth quarter of 2007. If this pace of buybacks continues, at an annualized pace of $500 billion, when the S&P 500's market capitalization is $17.7 trillion, it's easy to see how this activity places a short-term floor underneath stocks, especially large caps. However, as Buffett has often stated, it only makes sense to buy back your stock when it trades at, near or below its intrinsic value. Remember, this newly-issued debt needs to be serviced and must eventually be paid back.
Fear #5 (declining median income adjusted for inflation)
This quote from this New York Times article from September 2013 captures the lack of median income growth.
"For all but the most highly educated and affluent Americans, incomes have stagnated, or worse, for more than a decade. The census report found that median household income, adjusted for inflation, was $51,017 in 2012, down about 9 percent from an inflation-adjusted peak of $56,080 in 1999, mostly as a result of the longest and most damaging recession since the Depression. Most people have had no gains since the economy hit bottom in 2009."
It's a well-known fact that consumption drives approximately 70% of GDP. If median incomes aren't growing adjusted for inflation, and the job market isn't creating enough jobs, as it hasn't since the onset of the 2008 recession, it's impossible, longer term, for the U.S. consumer to drive consumption without experiencing marked improvements in their median incomes.
In the short term, consumers can take on debt to fuel consumption, but this is capped, as lending standards are heightened and servicing the acquired debt is a drag on future consumers' incomes, as not all future income can be consumed, instead, a portion will need to reserved to pay off some of this accumulated debt. This is pretty obvious stuff, yet the market is conveniently ignoring the weak structural economic underpinnings. The market seems to myopically focus on increasing earnings, without caring that some of these earnings are low-quality and unsustainable longer term without median income growth. Moreover, it's well-documented that the country booms when the middle class is gainfully employed and real wages are increasing. This stock market recovery really hasn't helped Main Street, the true driver of sustainable GDP growth.
Fear #6 (student debt and household formation)
It's well-chronicled that student debt has topped $1 trillion.
This in and of itself would not be a bad thing if freshly-minted graduates were greeted with a job market that welcomed them with open arms and generous pay packages to start servicing their student debt. Notwithstanding select technology engineers in the right segments of the industry and other pockets of strength, the job prospects of college graduates have been disappointing, really since 2009. Beyond being attractive to hire because new graduates earn less, most college students are increasingly price-takers and need to adjust their expectations downward to become gainfully employed. This uncertainty, coupled with the higher costs to secure a four-year degree has delayed adulthood, household formation, and inhibited the positive feedback loop.
In the past, a four-year education was a path into the middle class, and possibly higher, with talent reinforced with hard work. As the middle class felt secure and did well, new home buyers stepped onto the first rung of the housing ladder and started building home equity.
As the dynamics of this once-vibrant housing ecosystem are no longer functioning properly without significant Washington intervention, the younger couples who are looking to trade up for larger homes as they start families isn't occurring at the rate it once did. This is another headwind, as construction and housing are important components to the GDP equation.
Perhaps, due to lower confidence, higher student debt, and uncertain job prospects, the U.S. birth rates have been bouncing around at very low levels since 2008. This is yet another sign of the inherent weakness in aggregate demand not often talked about by highly-paid pundits on major financial news broadcasters like CNBC.
Fear #7 (Unfavorable demographics as the boomers age)
Given the seismic shift started in the 1980s away from defined benefit pensions, where the employers owned the risk of having enough assets to fulfill their promised pension liabilities, I read that generally speaking, some members of the first wave of the baby boomer generation are approaching retirement without the safety net of a defined benefit plan, and therefore, not enough savings in their defined contribution plans. Also, most boomers do not have enough savings to maintain their current lifestyles in retirement. Boston College's Center for Retirement Research has done some excellent research on this topic, and I would suggest you inquire there for more details.
Given the lack of savings, and in the aggregate, the lack of adequate financial assets among baby boomers, invariably, boomers might be forced to tap into their defined contribution plans sooner than they hoped to sustain their lifestyles. Given how low yields are on fixed income securities and how inflated stock prices are, notably the Russell 2000 index, at the margin, there may be an imbalance as the baby boomers need to sell riskier equity and financial securities in order to live, and perhaps, not enough well-off folks in the younger generations to redeem out the retiring boomers' equity portfolios. This is yet another headwind that will confront the market and riskier securities like the Russell 2000.
Fear #8 (Slow GDP in the BRICs)
I don't pretend to be an expert on international economies or equities. However, I know enough to be deeply worried about China, the world's number two economy. Although, weaker Chinese demand would most likely hurt large capitalization stocks more than the Russell 2000, if China hiccups, the world's so interconnected today that high-beta stuff like the Russell 2000 would most likely decline.
Recently, China has experienced decelerating GDP growth rates, currently projected at 7.5% this year, down from steady double-digit growth through the 2000s. Moreover, China has taken on massive amounts of debt at the local level, hitting the $3 trillion mark recently, in order to sustain its growth and prevent social unrest.
Other challenges confronting China are the abject pollution and corruption. I'll leave this to the popular press, but China's former premier's family has been accused by the New York Times of hiding hundreds of millions of dollars acquired through power and influence peddling. This type of corruption doesn't instill confidence in the eyes of the people, who are supposedly going to take the baton and seamlessly increase consumption to offset the over investment in the real estate and infrastructure segments of the Chinese economy. Also, interestingly, some of the Chinese elites are moving out of China in droves to pursue a better and healthier life for their families, after acquiring wealth from China's industrial boom. Unfortunately, air, water, and food regulations have taken a backseat to the pursuit of wealth creation by the connected elites largest created by padding infrastructure projects, for third and four airports that don't make economic sense. Famed short seller, Jim Chanos, has done incredible research on China's over-investment in infrastructure as a percentage of GDP. Lastly, China lacks sufficient financial regulations to protect consumers from shadow banking fraud, including unregulated as well as inadequate access to healthcare and a social security system. It's perfectly rationale for relatively poorer Chinese to prudently maintain high saving rates to fund their modest retirement. Another ominous sign of China's slowing growth is the signal from the copper market when copper broke the $3 per pound level.
I'll spare the reader the high-level overview on Brazil, India, and Russia, but clearly, growth rates have slowed dramatically in all three places, and inflation is a major issue in both Brazil and India. The Brazilian economy grew at a disappointing rate of 2.3% in 2013, a far cry from its glory days in the high single-digits. This slower growth hurts demand for U.S. corporations that sell their goods and services abroad. We can have different perspectives on intermediate-term future economic prospects of BRICs, but at least in the short term, the data clearly points towards many challenges in all four places and at the margin slower growth compared to a few years ago.
Fear #9 (NYSE margin debt and mutual fund inflows)
As of month-end January 2014, NYSE margin debt stood at $451 billion, up sharply from January 2013, when it was $364 billion and $276 billion in January 2012.
Also, one could hypothesize that given the high 30%-plus share price appreciation of the Russell 2000 in 2013 that the U.S. mutual fund industry experienced record inflows. Well, yes, there was an estimated $60 billion in net inflows, but this the first positive net inflows since 2005, according to the WSJ.
Although $60 billion is nothing to sneeze at, as stated earlier, U.S. corporations bought $128 billion worth of company stock in Q3 2013 alone. Not to mention that NYSE margin debt is $451 billion, or materially more than the $60 billion in retail equity fund flows. Translation, if anything, investors very well may be suddenly chasing and rushing back at exactly the wrong time, after stocks recorded gains of 2013. If anything, this is more likely a contra-indicator that stocks are vulnerable, especially the Russell 2000.
2013 marked the highest IPO volume and absolute capital raised since 2007. In fact, last Friday, March 21, 2014, 6 IPOs opened for trading on the major U.S. equity exchanges. This may be another contra-indicator, as insiders are cashing out by selling into a market with an unquenchable thirst for new issues. Perhaps, the most egregious example of frothy taking place in today's stock market is the insider selling at Yelp (NYSE:YELP); a company where insiders have unloaded $911 million worth of stock.
What's so outrageous is that Yelp is trading at a revenue multiple of 15X FY2014, yet, Yelp has yet to make a GAAP profit, and hasn't proven they can profitably scale this business, as its customer acquisition costs are expensive. Lo and behold, this is a Jim Cramer darling, another sign of the top. Moreover, it's almost insulting that investors are happy to cash out Yelp insiders at absurd valuations. This is classic greater fool theory based on momentum.
Fear #10 (Underfunded pension obligations or municipalities)
Although last year's stellar equity performance clearly helps the funding ratios of public pension plans, the turmoil in Puerto Rico and Detroit are perfect examples of how kicking the can down the road, population losses, lack of investment in schools, corruption, and mismanagement can cause very dangerous longer-term problems.
These two basket cases, specifically, are the test case of what can go wrong when politicians overpromise longer-term benefits to get elected and are long gone when the bill comes due years down the road. Frankly, it's pretty sad that the debt market enabled the most egregious municipal borrowers to hide these problems through purposely convoluted accounting to obscure the truth to remain in office. In the process, investment banks got paid nicely underwriting fees.
There may be a silver lining, as this may mark a sharp inflection point and the end of the era of promising people benefits to get elected. The current challenges of today require much more open, honest, and transparent leaders to mitigate these disasters.
It's an unenviable task when the pension interest payments and required annual contributions start crowding out the budget formerly reserved for existing services like investing in schools, roads and infrastructure, public safety, and basic service like trash removal.
The lack of transparency, easy access to credit, and slow economic growth are pitting retired pensioners, who rightly earned their pensions, against current taxpayers that have different desires for how they want to see their hard-earned tax dollars allocated. This is another negative headwind, as it may mean reduced services, higher taxes, and broken promises to unfortunate retirees who were unlucky to have work in municipalities run by incompetent people.
Given the exhaustive and comprehensive list of fears that I have documented above, it's prudent to reduce market exposure to the Russell 2000 Index. If you do not want to reduce your overall aggregate level of equity exposure, I would strongly suggest rebalancing your high-beta equities like the Russell 2000 into large capitalization value stocks, which offer some downside protection through their dividend income, less volatility, more diversified revenue streams, and better valuation. Again, the Russell 2000's major leg-up had been driven largely by multiple expansion and earnings that are artificially inflated for the reasons stated above, which actually understates how risky it actually is to own shares in the Russell 2000 at the present time.