David Rosenberg, famed economic/portfolio strategist and current chief economist of Gluskin Sheff & Associates, posted a warning to investors everywhere in the February 15 Financial Times. The premise of his argument is that we are currently in a bear market rally – a substantial rally, but a bear market rally no less and that the rally is probably in its final stages.
- Mr. Rosenberg seems to view the economy in the context of a 10-year struggle to recover from the recession in 2000. He argues that the stock market rally from 2003-2007 was little more than a bear market rally “driven by phony wealth generated by a non-productive asset class called housing, alongside widespread financial engineering that triggered a wave of artificial paper profits.”
- Rosenberg argues that the current bear market rally is driven largely by fiscal and monetary stimulus vs. some tremendous productivity enhancing innovative technology. He questions what today’s major innovation is, “The iPod? The iPad? Facebook?”
On a minor digression: many people criticize the use of hedonics in calculating inflation indexes. For those wondering what hedonics is, hedonics is basically a method for adjusting the “value” of something via price adjustment to reflect quality changes. In a rudimentary example: if tomorrow’s iPad is 2x faster, has a higher resolution screen, more storage, etc. AND the price is unchanged vs. the first generation iPad ... the powers that be make some sort of implicit price adjustment to reflect that you are getting more equipment for the same price which is to say it is cheaper, in theory, than the first generation iPad. In effect, people argue that hedonics inappropriately pushes the CPI calculations down or at least prevents them from properly reflecting the rising costs.
My take on hedonics: For the better part of two decades, tremendous innovation across the supply chain and in products among many industries likely justified the use of hedonics. Computers that doubled in chip speed every year or two actually translated to substantial gains in productivity. However, at this point ... how much incremental productivity does the new iPhone or Windows 7 actually create? As David Rosenberg points out, “These may be fun, but they don’t do much to promote the growth rate in the nation’s capital stock or productivity.” Thus, I too am starting to question the underlying merits of using hedonics and its implication in inflation calculations. End digression.
- It all comes down to valuation and what the appropriate earnings multiple is given the macro risks present. According to David Rosenberg, “What we have on our hands has been an economic revival and market bounce back premised on unprecedented monetary and fiscal stimulus. How the Federal Reserve and the federal government in the future manage to redress their pregnant balance sheets without creating a major disturbance for the overall economy is a legitimate question and, sorry, does not deserve a double-digit market multiple.”
Dave’s take: “The best buying opportunities for investors who have time horizons of more than five or even 15 months for that matter – those investors who are more focused on building wealth for the long-term as opposed to trying to make recurring short-term trading profits – will happen when we see the payback period. And this could happen sooner than you think. Do not assume that Ben Bernanke, chairman of the Federal Reserve, has any more rabbits in his hat or that the new Congress is going to fill anyone’s stockings with more fiscal goodies toward the end of the year.”
My take: Rosenberg might be on to something here, and he isn’t the only one when you stop and think about it. When the S&P 500 was in the mid 600s, it was a no brainer buy for a lot of people. Last year, David Tepper argued that the market was essentially a no brainer buy given the dual outcome of either QE2 or a stronger economy – either way stocks were - generally speaking - poised to move higher in his view. Today, with the market substantially higher, these folks are arguing that the market is simply not in “no brainer buy” territory and as such it is probably prudent to cut risks in areas of less confidence and to maximize optionality.
Rosenberg points out that in their equity strategies, they are “minimizing cyclical exposure and have a focus on an income equity-hard asset barbell." Unfortunately, long term government bonds are not even a very appealing alternative with yields so low. Case in point: PIMCO has reduced exposure to U.S. treasuries while increasing exposures to "good credit risks." Perhaps the key going forward is taking some exposure to credit risk and other higher yielding instruments, some exposure to hard asset/materials, and then lots of cash. Cash might have little yield but it has a hell of an option value when/if equities tumble 5%, 10% or 20% over the next 3-18 months. Warren Buffet wouldn't have had so much success if he didn't have substantial amounts of cash to buy companies when Mr. Market placed them on a large discount.
Good luck and thanks for reading.
Click here for Financial Times article.