- In all up markets there are both eternal optimists as well as popular pundits who shout for doom and gloom.
- Look to arguments for downside risk that use logic, rather than negative buzzwords and blanket sell-side statements that are poorly constructed.
- Stay bullish on stocks due to investor sentiment, valuation and the state of the political economy.
"Free-market capitalism is the best path to prosperity." - Lawrence Kudlow
During America's reign as the leading economic engine of the world, the domestic stock market has generally captured the nation's economic cycles by growing alongside expansionary phases and waning in times of recession.
When times are booming, investors always know in the back of their head that good times may not last forever and that at some point the business cycle may contract and negatively affect the pricing of the general stock market.
While downside always remains a risk, during these times of economic expansion and general market upswings there always remains eternal optimists as well as those shouting for doom and gloom.
While the bears who are shorting the market, as well as those who are in-cash with no stock exposure may eventually be right, investors who fall for "bearology" during periods of stock euphoria will own portfolios that perform poorly. With cash returns in the U.S. at all-time lows, this is even further exacerbated as all-cash investors risk losing money to inflation.
How To Judge Bearonomics In An Up Market
While it's popular to be a bear when the market is down and the headlines are overwhelmingly negative, most of them hibernate during market upswings.
There will always remain a few popular pundits who want to fight the tape in upswings however and as an astute investor, it may pay to listen as long as logic is used to uncover downside risk.
One financial market pundit who has received headlines lately is Bill Fleckenstein, president of Fleckenstein Capital. According to his thesis stated on CNBC on Tuesday March 25, 2014, Fleckenstein states that when the Fed relents on the taper, stocks will fall.
According to Fleckenstein, "... the only reason interest rates are at zero is because it's the same Fed that has caused the stock market to be infected with lunacy again."
Time for the Gummy Bear Martini?
Before investors jump on his bandwagon and start ordering bear-tinis, one must look at the logic of his argument which could be considered weak and full of red flags.
First off, Fleckenstein starts with the legitimate thesis that stocks could fall when the market can see the end of QE-Infinity, whenever that may be. Rather than develop this thesis, he turns to negative buzzwords like "lunacy," rather than hard statistics to follow the logic.
Just because someone says the stock market valuations are full of "lunacy" does not mean investors should bet against the bulls. If he said "stocks are historically trading at twice the valuation they normally trade at" we would have a fact, however according to Fleckenstein's interview, no facts were justifiable to include on his television appearance.
While his antics may also be supported by the fact he was right to short stocks in 2008 then go long in 2009, investors need hard logic to buy into his proposition.
In going back to January 2014, Fleckenstein tried to make sense of his logic to investors through valuation-related propositions to support his thesis that QE is keeping the markets afloat and that stocks are overvalued.
According to CNBC, Fleckenstein's remarks were as follows:
"The (price-to-earnings ratio) is 16, 17 times earnings," Fleckenstein said on Tuesday's episode of "Futures Now." "Why would you pay 16 times for an S&P company? I don't care about where rates are, because rates are artificially suppressed. Why isn't that worth 11 or 12 times? Just by that analysis, you'd be down by a quarter or 30 percent. So there's a huge amount of downside."
In looking at his evidence, today the S&P 500 trades at 1,861 (intraday March 26, 2014), which is higher than the 1774.2 closing price on January 29, 2014, the day of the interview quoted above.
According to Howard Silverblatt, the S&P senior index analyst with S&P Dow Jones Indexes, 2014 S&P 500 earnings are estimated to be $120.29 per share (as of March 20, 2014). This puts the 2014 P/E ratio of the index at 14.75 on January 29, 2014 and 15.47 intraday on March 26, 2014.
Using 2013 the S&P 500 EPS of $107.29/share, the trailing-twelve month P/E ratio would be 16.54 on January 29 and 18.28 on March 26.
While that seems high and Fleckenstein was absolutely correct to state the market was trading at 16-17 times earnings back in late-January, this does not take EPS growth into consideration. When the market is expected to grow 12.1% in 2014 and maintain a 12.1% growth rate for the next five years, a forward P/E ratio of 14.75 (now 15.47) does not seem frothy at all.
To add to this argument against Fleckenstein's overvaluation plea in terms of the current, ultra-low interest rate environment, investors should take note of the earnings yield. As the P/E ratio is but a number that can relate to current peer valuation and aggregate past valuation, the earnings yield can be used to measure the risk premium versus other assets.
Currently the 2014 earnings yield on the S&P 500, using $120.29 as the EPS estimate for the index, is 6.46%. In looking at the yield versus the 10-year treasury and the 10-year Moody's Baa (lowest investment grade bond) 10-year yields, which are 2.7% and 5.03%, respectively, it appears that stocks are undervalued using both the Fed Model and more advanced capital structure substitution theory.
In looking at risk premiums, they would be as follows:
At this rate, investors are receiving a risk premium of 376 basis points over the risk-free, 10-year U.S. treasury bond yield. In addition, investors are receiving ownership in a market that aims to grow 12.1% per year for the short-term, according to S&P Dow Jones Indexes.
Fleckenstein's valuation argument, while potentially correct in individual names with sky-high P/E valuations, seems fundamentally flawed on a general market basis.
In addition, his argument that stocks will fall when the end of QE-Infinity is in sight is also very general and is not supported by factual evidence.
The purpose of quantitative easing is to both stimulate the economy and increase general employment levels. The Fed aims to end this program when the economy is hot and growing at faster levels with full employment, or a measurement close to full employment, which we are nowhere near yet.
While the "full employment, or a measure close to full employment" statement is not factual, it is supported by evidence as Yellen's first testimony as Fed Chair moved away from the sign that a specific-employment level would be the threshold for a rate hike.
According to Yellen,
"The unemployment rate is not a sufficient statistic to measure the health of the labor market."
This could be seen as a measure to push the economy into much fuller employment that the 6.5% threshold that most economists generally used to predict a rate hike.
While the bears may always be right, eventually, giving credence to those with valid arguments can be fruitful for investors.
For example, Peter Schiff gave investors warning that the market prices in housing could not be sustained or supported many times before the great financial crisis hit.
He supported his warning that stocks would fall and that a recession would occur by using facts, rather than just shouting buzzwords such as "absurd, lunacy, bubble," etc..
In 2005, Schiff stated the run-up in gold, oil and other commodities were moving up against the dollar, Yen and Euro, which was a sign of inflationary pressures and a move in interest rates up in Europe. Such a rate hike in Europe would push interest rates higher in the U.S., which would shock the housing prices which were in bubble territory.
After the Fed then raised rates considerably into 2006, Schiff then predicted a recession that "is going to be pretty bad" beginning in 2007 or 2008. His thesis was that there was too much consumer spending and that when home-equity evaporates, due to over-priced housing, that Americans would have to rebound by increasing savings.
His main argument is that when "you see the stock market come down and the real estate bubble burst all that phony (household) wealth will evaporate." This was a "wealth effect," so to speak, that Schiff argued was supporting a weak market and could not continue.
As the housing boom accounted for 30% of the economy in 2006, the argument became on that the economy was a housing economy that needed housing to continue to grow. Schiff argued that the bubble would burst due to the unaffordability of keeping up with adjustable-rate mortgages that would drown many homeowners.
"A lot of people have adjustable-rate mortgages that are going to reset of the next couple of years ... people are going to see their monthly mortgage payments go up by 50%, 100% ... a lot of that is going to take a lot of spending out of the economy."
While Schiff has been and continues to be seen as sort of a wild-card pundit in the financial mainstream media, this time his thesis was supported by baskets of hard evidence and logic that made sense. As we know now, consumers could not keep up with their payments once they reset, housing collapsed, the economy tanked with housing and the 2007 levels in the S&P 500 were not seen again until 2013.
The Bull Argument Still Wins, Buy Stocks Today
In conclusion, investors cannot take pundits seriously when they use emotional appeals to sell stocks that are not supported by evidence and logic.
Today's stock market remains intact, with five years of momentum pushing the S&P 500 Index to higher and higher levels. With the market currently only 1.7% off its 52-week high, which was achieved only three trading sessions ago, the continued uptrend appears to be sound.
In terms of valuation, with an earnings yield of 6.5% as of market close on March 26, 2014, the market holds an appropriate risk premium over corporate bonds and the 10-year treasury.
Also, at 6.5%, the P/E is 15.4. To account for short-term growth of 12.11%, the PEG is 1.27 which is close to 1, for those who use the PEG ratio. The EYG root is 8.87, which suggests a very attractive market valuation level.
Regarding investor sentiment, there is general-market hype that gives notion of stocks advancing forever. There is a mix of optimism and pessimism with the markets up in general, which suggests stage two of the Howard Marks Bull Market Cycle, as seen below.
As far as the political-economic arena, there are global threats as always that may hinder growth, however there does not seem to be any major catalyst brewing that could push the domestic economy into a recession.
The Federal Reserve seems bent on keeping rates low until the economy is strong enough in terms of GDP growth and employment levels, as well as to push inflation higher, before raising rates. Yellen is historically known as a dove and has stated that there are many more points of economic reference she will look at that are deeper than an employment target.
When the appropriate evidence and logic suggests that the party is over and that profits should be taken in this economic cycle, investors will be smart to listen. For now however, investors may be smart to overlook the market pundits who use fear and negative buzzwords to try to emotionally convince investors to play into their bearology.
To learn more about investor sentiment and how it affects markets today, please read "Now Is The Time To Be Bullish (Part 1): Investor Sentiment," published September 23, 2013.