This is the second part of a two-part series. Part 1 is here.
10. What if the US economy experiences a major recession? If I believed that the crises in Europe and a hard landing in China could trigger a deep and prolonged recession in the US, I would be targeting 800 or lower on the S&P 500 (GSPC).
As things stand right now, my base case is for a significant slowdown in the US economy, or possibly a short and shallow recession.
Why do I only forecast a slowdown and not a major recession? I believe that forecasters such as ECRI that are predicting recession are being mislead by indicators that historically have exhibited "leading" characteristics but under today's circumstances are actually lagging. Quantitatively driven models work when conditions are typical; they can mislead when circumstances are atypical.
For example, in the past, indicators of global cyclical activity have been good leading indicators of the US business cycle. However, currently, many global economies such as Europe and China are set to enter the first phase of a deleveraging process, whereas the US is already well along in its own deleveraging process and is in the process of experiencing a bounce in consumption and investment. This means that if you are looking outside the US for "leading" indicators, you may be misled. What you may find are economic indicators tracking processes that are lagging those of the US.
Another issue to take into account is the capacity of the US economy to withstand an exogenous shock. Historically, in a typical US business cycle, companies tend hit by exogenous shocks (such as rising oil prices) late in the business cycle and are caught with excess capacity in terms of labor, equipment and inventory. The shedding of this excess capacity causes a large economic impact in terms of lost employment, production and consumption. The present situation in the US does not fit well with this typical patter.
First, it is still very early in the business cycle. Second, US companies have aggressively shed excess capacity and "fat," and are running extremely "lean" at the present time. This means that if a global crisis occurs, it will hit the US economy early in the business cycle and in a relatively "lean" state. Thus, under current circumstances, the impact on the US economy of an exogenous shock may be relatively muted compared to that which typically occurs.
Please note that US corporate balance sheets have scarcely ever been in better shape in terms of low debt and high cash levels. US consumer debt service burdens have also fallen dramatically to levels not seen since the early 1990s. US financial institutions such as JP Morgan (JPM) have built up large capital buffers. These factors add strength and limit the downside for the US economy.
11. Potential confrontation with Iran. A military confrontation with Iran would probably seal the fate of global economies. A sustained spike of oil prices above $130 would be a recession trigger around the world. I have no special insight on whether a military conflict with Iran will occur in 2012. However, Iran's apparent determination to develop a nuclear weapon means that an attack on Iran is likely only a matter of time. Each day that passes, Iran comes closer to developing a nuclear weapon. Therefore, each day that passes raises the probability of an attack on Iran by the US, Israel or an alliance of nations determined to prevent such an outcome.
12. Global policy responses. If governments and central banks around the world did not have the ability to apply countercyclical stimulus I would set a lower target for the S&P 500. But the fact is that is that global governments and central banks can and will eventually adopt aggressive measures to contain the crisis. In particular, in order to avert depression and deflation, global central banks will risk inflation. This "inflation bias" on the part of modern central banks act as a "put" that places a floor on equity values.
13. Timing. There is nothing intrinsic in the fundamental outlooks in Europe and/or China that imply the need for a crisis on a particular date. The search for crisis catalysts is necessarily probabilistic in nature.
On October 27 of 2011 I predicted that within the next six months the S&P 500 will have commenced a downward move which will take it to the 950-1,020 range. Another way of putting this is that the stock market will top out before April 27, 2012 and will subsequently decline to the 950-1,020 range.
The reasons for looking at the period prior to April 2012 for a catalyst are the following:
- 1Q GDP and budget estimates. By late March of 2012 it will be abundantly clear that PIIGS economies are contracting by more than expected and that violations of their fiscal commitments will be greater than expected. A diplomatic showdown with Germany should ensue that is likely to greatly destabilize global financial markets.
- Fiscal union approval. Eurozone leaders have settled on March as the deadline for implementing their "fiscal union" agreement. The problem is this: If the fiscal restrictions are credible, approval by member states will be threatened. If the restrictive language is eased, the agreement will no longer be credible. Either way, there will be high drama in March. In particular, it should be clear by March that the very first fiscal targets will be violated thereby charging the political and diplomatic atmosphere surrounding the fiscal union legislation with negative energy.
- Elections. There will be national elections both in Greece and France. Prospects are high that candidates will ramp up populist rhetoric directed against austerity policies and the relinquishing of national sovereignty. In particular, a loss by Nicolas Sarkozy in France would be particularly destabilizing as both of his opponents are running on platforms that imply greater confrontation with Germany.
- Spring thaw and protests. The spring weather means that protesters can take to the streets and take possession of public spaces. With youth unemployment in PIIGS nations running between 30% and 50%, it would be amazing indeed, if 2012 could pass without major social and political instability. By April, global financial markets may already have a taste of the sort of social and political strife that awaits in the spring and summer of 2012. During 2011, young people in the Middle East, Europe and the US got a sense of how they could alter the course of politics in their countries. They also gained much experience regarding organization. Under such circumstances, considering the state of the job market around the world for young people, it will be extremely surprising to me if global protest activity does not ramp up dramatically around the world. The consequences of such activity could be dramatic. 2012 could shape up to be a pivotal year in world politics and economics, much as 1968 was.
On October 27 of 2011 I predicted that within the next six months the S&P 500 (SPX) will have commenced a downward move which will take it to the 950-1,020 range. I explicitly left open the possibility that US stocks and index ETFs such as SPDR S&P 500 (SPY), SPDR Dow Jones Industrial Average (DIA) and Powershares QQQ Trust (QQQ) could make substantial gains and even 52-week highs in the interval. In addition, it should be noted that the April 27 date is the deadline for a top, not a bottom. It is the date by which the next leg of the bear market will begin, not necessarily end.
Readers should note that while I do expect a major collapse in commodities prices, I, don't expect a collapse in US equities such as occurred in 2008-2009. The US private economy is quite lean. Furthermore, economies and markets around the world have had considerable time to brace themselves for turbulence. Finally, policymakers around the world have myriad tools at their disposal to prevent slowdowns and recessions from turning into depressions.
950-1,020 on the S&P 500 is not a level of prices indicative of doom and gloom. On a normalized earnings basis, a value of 1,000 on the S&P 500 represents a P/E within a "normal" range in a historical distribution, albeit at the low end. If I expected a deep and/or prolonged recession in the US or inept policy responses around the world, my target would be considerably lower.
People sometimes ask: What if you are wrong? I could be wrong two ways: Up or down.
For example, I could be wrong and the market could conceivably go as high as 1,600 within twelve months. By the same token, I could be wrong and things could get much worse than I expect. For example, there are scenarios in which the US could join the rest of the world in a deep and prolonged synchronous recession. In that event, a retest of the 2009 low at 667 is hardly far-fetched.
From a reward/risk perspective within a 12-month framework, it makes little sense to invest in a market when one's base case is a 300-point loss, maximum upside is a 300-point gain and maximum downside is a loss of 633. Reasonable dividends would not alter this conclusion.
I do not advice purchase of stocks at the present time. Not even apparently attractive equities such as Apple (AAPL), Microsoft (MSFT), Intel (INTC), McDonald's (MCD), or Pepsi (PEP). Cash is the asset of choice. Given my assumptions, on an expected return basis, cash is the asset that provides the greatest prospect of increasing real wealth in the next 12 months. On a risk-adjusted basis, it is no contest. I expect the value of cash to rise substantially relative to the price of stocks and the value of dividends paid.
If you believe, as I do, that the economic and financial situation around the world will deteriorate in 2012, to target a normalized valuation at the lower end of the historic range is merely being prudent; hardly alarmist.