The week before last, in one in a series of cautious to bearish articles on the market (NYSEARCA:SPY), I promised a new article that would address the downside risks to the market. This is not the most pleasant topic to write about. I'm long certain stocks and have no shorts, puts, etc. Perhaps more important is that whatever reputation Seeking Alpha has had for being a haven for short sellers is long gone. There's little upside to a SA writer to rain on anyone's parade. Stocks are assets and an important part of the wealth generation and preservation plan for many people. In addition, there's a lot more interest in articles on specific companies.
Nonetheless, a promise is a promise, and I wrote up a long, detailed draft article showing all sorts of dangers in today's market. It was so gloomy and amounted to throwing fire on the flames that I did not submit it. Now that the market is actually breaking and Jim Cramer put on a technician talking about $135 or even $122.5 on the SPY, I'm going to submit an updated version to the editors.
The following headline shows one of the most important points I want to make. It's the almost dazzling complacency of the financial media.
As reported by a columnist for London's Telegraph:
Clients told to seek safety of Bunds and Treasuries. 'This is about return of capital, not return on capital. In a crowded hall, exit doors are small'
But all the brokerage was predicting was a 20% decline. For a deflationary crisis?
This is almost bizarre. I believe that the DJIA (NYSEARCA:DIA) suffered 20% declines in 1962, 1966, 1977, 1978, 1987, 2000 and 2002 with no recession at the time, and no deflation.
I have an opposing view, which I present next as one of numerous (infinite) possibilities. This view is that an extreme drop in the averages could occur with only a mild recession, something like the 2000-2 experience.
There's an important corollary, which is the positive side of the argument. That is the case that interest rates would likely drop in high-quality bonds in such a scenario, perhaps to new cycle lows in the US.
The core argument against stocks in the short or intermediate run
It's actually pretty simple. As I write this draft of the article, the SPY pre-open is around $184. Trailing 12-month earnings for the S&P 500 through Q3 2015 are just over $90, so let's call it $9 for the SPY. That puts P/E's using generally accepted accounting principles at, say, 20.
Point 1: Margins are problematic
Unfortunately for those who agree with Warren Buffett that profit margins are the most mean-reverting metric in capitalism, seen on Dr. Yardeni's website (Figs. 23-25), margins could easily drop by 1/3.
Thus the mean-reverted P/E is around 30X, and it could be higher if margins drop to their historic lows.
One important point is that an economically good reason that margins could drop would be that labor is reclaiming a greater share of the economic pie in the US. However, stocks are investments in business, so owners of business may be on the back foot for a while after decades of seeing labor's share of sales decline to perhaps all-time record lows. That's one reason I'm not necessarily gloomy about this phenomenon.
Point 2: Why should profits increase this year?
The Street has been wildly bullish about a snapback in profits for 2016 and beyond. All earnings have to do is stay even to disappoint forecasters, and if margins decline, then profits could decline even if the economy performs fine, with no crisis at all much less outright deflation. S&P is predicting GAAP profits for this year of $118.50 for the '500.' Color me unconvinced given the weak, deflationary economic data reported all last week, culminating if very disappointing data on Friday.
Point 3: P/Es also have mean-reverted
Both GAAP P/Es, the fantasy "operating P/Es" and Shiller P/Es sing the same tune: ZIRP has driven P/Es to very high levels. Yet historically, when deflation or deflation fears have driven interest rates on high-quality bonds very low, P/Es have from time to time been low. So have valuations based on Mr. Buffett's favorite indicator of market cap to GDP, price:sales, and others. So if we simply assume the same $9 EPS for the SPY as has been reported through Q3, translate today's 20X P/E to a margin-adjusted 30X, we would be well within historical norms to assign the market a 10X P/E.
That would imply a SPY of 1/3 the $184 current value, or about $61.
Now, that's not a prediction, but note it is below the famous intraday low of $66.6 on the SPY set at the bottom of the 2008-9 crash. If that happened, the technical shock waves could be immense and take P/Es to 7X, as has occurred at the bottoms of oversold, crashing markets.
Now, nothing like this could happen overnight, and the secondary effects of such a dire situation would have all sorts of unpredictable effects. One effect we could predict, though, is that if anything like a mild recession and vicious stock market crash occurred, the Yellen Fed would change its tune and ease, and stop its misguided tightening talk.
That in turn opens up the topic I've been writing about for years, namely the structural trend toward lower rates on Treasury and other high quality bonds. I focus on Ts (as I call them for conciseness) due to their liquidity and their non-callable nature.
Ts offer both safety of principal, income and the chance for capital gains. I believe that most individual investors are underweighted in them and that both individuals and foreign investors will be looking more carefully at them if the SPY continues to struggle or goes into a full-fledged bear market. Here's an update.
The updated case for Treasuries
As RBS reported, there have always come times when investors go risk off and scramble for return of their capital. Temporarily, they forget the inflationary growth of the early parts of the economic cycle. Now the talk is of gluts, debt deflation, bear markets in stocks, hedge fund and other fund redemptions, and bank solvency worries.
If that scenario, or some variant of it, becomes more prominent, surprisingly to many, Ts are in good shape to go higher in price (lower in yield). Here is a summary of the case for them.
Point 1: International comparisons favor Ts:
Treasury yields are much higher than govvies from Canada, the UK, Germany and Japan. However, ultimately government bonds reflect the safety of the issuer. With no debt denominated outside of US dollars and still the world's sole superpower, there is no safer place for money than the US. In a crisis, it is US govvies that can be the lowest-yielding of all currencies (perhaps Switzerland is an exception).
Point 2: Treasuries are not callable
This is a major advantage that Ts have over the great majority of corporate and municipal bonds. Most of them can be taken away by the issuer before maturity, so owning the bonds can offer the downside of higher inflation and higher rates without the upside if inflation and rates stay low or drop further. Thus a 20-year T-bond offers a guaranteed income stream for exactly 20 years, after which the principal will certainly be returned. How much the principal will be eroded by inflation is not, of course, guaranteed. But that's true of everything from money in the bank to stock prices, which from 1965-82 went down despite high, sustained inflation.
Point 3: Treasuries offer trading and long-term capital gains potential
A corollary of their non-callable status is the ease with which Ts can be sold for trading profits. If interest rates on 30-year Ts drop from a recent level of 3% by one point to 2%, then about a 35% trading gain would be obtained by a trader buying high (in yield, low in price) and selling low in yield. (This analysis relates to zero-coupon Ts, which pay no current interest and therefore are more volatile than the much more prevalent interest-bearing Ts.)
Point 4: Treasuries are liquid in a crisis
While during a financial crisis, all assets become less liquid than before, one can sell a T-bond when one cannot sell a muni or shares in a lightly-traded stock, and with acceptable bid-asked spread.
All the above combine to make Ts excellent hedges against a crash when the headlines scream deflation.
Technicals on Ts
We're all familiar with the technicals on the SPY and whatever other stock indices we follow. The technicals on Ts are less well-known. They are actually poised to drop to new lows based on a pattern that's been going on since the 1980s. This is the tendency of Ts to noodle around a new, lower yield level that is always proclaimed to be "it" from which a new, rising-rate cycle will appear. Yet whether it's 8%, 6%, 5%, and now perhaps 4% and even 3%, and whether it's the 10 or 30 year T-bond, so far after a number of years in which investors got used to the new yield level and expected rates to rise, they have dropped. We first saw the 10-year T drop to 2% during the post-Lehman period. It's still there, but it's been below 1.5%. If investors come to believe that the Fed will be on hold for years to come, then even 1% a year beats zero. So the 10-year can drop to 1%, crazy though that sounds. It's still higher than rates on several European govvies.
We have thus seen the benchmark 10-year T in its current trading range since late 2008. With our neighbor Canada's 10-year at 1.10% and the Netherlands at 0.62%, 1% for the US given its safety is strangely not unreasonable. It may finally be time for the 10-year to break below its lows and establish a new, lower trading range.
The 30-year T is more for either insurance companies, traders, or very cautious savers. Typically I have observed that whether it's Japan, Germany or the UK, and in the US, the 30-year rarely trades more than 1 point (100 basis points) higher than the 10-year. So if the 10-year T drops to 1%, I would expect the 30-year to drop to or below 2%. This would undercut its 2015 all-time low and also perhaps establish a new durable trading range.
Beyond those longer-term views, on the short-term charts, the moving averages and momentum indicators I follow are bullish for Ts of all durations.
How to invest in Ts
There are lots of ways. It takes time to set up and does not provide trading liquidity, but Treasury Direct cuts out the middleman and allows savers to deal directly with the US Treasury.
A second way is to buy individual bonds, say from any broker than handles bonds. The retail investor will not pay the price that an institution pays, but it's not usually a big hit. If one holds the bond for years, then one avoids the charges a fund imposes, and one has an asset that matures rather than a fund that is perpetual.
Among the funds, the iShares may be the most liquid. Their 7-10 year fund (NYSEARCA:IEF) and their long-term fund (NYSEARCA:TLT) are highly liquid, typically with one cent bid-ask spreads. They also have a 10-20 year fund (NYSEARCA:TLH) which has high current yields and trades even farther above par.
More adventurous are zero-coupon T-bond funds. These invest in very long-term Ts that pay no current interest, though they do return trading profits to shareholders quarterly if possible. The only two that I'm aware of are run by Vanguard (NYSEARCA:EDV) and PIMCO (NYSEARCA:ZROZ). The PIMCO fund has longer duration than EDV and similar liquidity, thus it's more exposed to the ups and downs of the long bond. Neither EDV nor ZROZ is a good vehicle for very short-term trading due to bid-ask spreads that are almost always larger than we are used to; and, they tend to widen during periods of market illiquidity.
Many other funds, both ETFs and mutual funds, own only Ts or their close relatives, agency bonds.
Not mentioned are shorter-term vehicles that are more in the realm of wealth-preservation vehicles than those mentioned above.
Concluding points - a difficult situation
I've been saying for months that stocks were dangerous, and that they did not need a recession to prove so. Whether the US economy is in or heading toward a recession soon is not my focus. It's that valuations are stretched severely. Just as a reminder, this is how stretched they have been. Note well that before 1990, the same chart would have had even a lower average line; the markets of the past quarter century have defined stock market deviancy upward. While this chart shows CAPE and q, it works for every important metric I know:
US CAPE and q chart
And the key commentary from its creator, economist and financial historian Andrew Smithers:
As at 6th January, 2016, with the S&P 500 at 2013, the overvaluation by the relevant measures was 68% for non-financials and 84% for quoted shares.
Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has surpassed the other previous peaks of 1905, 1936 and 1968.
My view is that the Fed has openly and deliberately led markets to this situation. However, my further view is that the SPY has slipped away from the reality of the real economy.
I have no possible way of knowing what comes next. Today could be a great "up" day in the market, due (say) to the Fed promising more candy for the stock market. Or, this could be the end of global disappointing economic news and the trend could be up for commodities, interest rates, and stocks, with safe bonds the huge losers.
These are important considerations for all money managers and investors.
My view remains unchanged. That view is that the Fed has blown the greatest financial bubble, including equities, junk bonds and Treasuries, and until 2011 commodities, in its long history. A follow-on is that with the economically-sensitive commodity complex and now junk bond complex breaking down, stocks are more likely next in line to see their bubble or near-bubble burst than Ts. There simply wasn't much speculation in Ts, but speculation was rampant in stocks. Today's headlines are supportive of this view that stocks have extreme intermediate-term downside risk. The lead news headline on Bloomberg is of falling consumer prices. The next article says Housing Starts in U.S. Unexpectedly Declined 2.5% in December.
These reinforce the message of the UBS deflationary scare headline quoted above.
One of the problems even with cash in these times is that possibility of negative interest rates. It's not a "normal" situation by any means.
They may ultimately lead to a similar sort of revaluation of the trading price of US businesses lower as has occurred with oil. I wish I knew, but that's markets for you; we always have imperfect knowledge if we want to achieve alpha. Beginning around the time of a June 2015 article in which I said that "the U.S. stock market is arguably in a bubble, or at least at a dangerous valuation point. If so, all stocks are dangerous," I have been cutting my exposure to equities. This trend has continued, consistent with the cautious-to-bearish tenor of a number of my articles over the past several weeks.
While I continue to own and like several stocks, including Gilead (NASDAQ:GILD) as my #1 holding and Regeneron (NASDAQ:REGN) as #2, more importantly I've respected the past precedents that highly-valued markets that start moving down are dangerous.
Based on the above analysis, I believe that US stocks remain dangerous, at least on a trading basis, even if the economy does not enter recession. Thus, at this point, I remain structurally underweighted in stocks and overweighted in Treasuries and other high quality bonds.
Thanks for reading. Any comments you would care to share are appreciated.
Disclosure: I am/we are long IEF,TLH,TLT,EDV,ZROZ,GILD,REGN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.