It's Time To Sell Your Stocks (Again)

| About: SPDR S&P (SPY)

Summary

I recently caught up with one of the smartest stock market professionals I know. We discussed the economy, earnings, and the outlook for stocks.

The "echo boom" is over. Birth rates are near all-time lows and low interest rates have created a high-competition environment. These factors are converging and will sink the current recovery.

We conclude that the stock market has rebounded to a level that fundamentally represents extremely unattractive risk/reward for investors.

In our most recent Seeking Alpha article, I presented an industry expert's view on Juniper Networks, utilizing an interview format.

More recently, I caught up with one of the smartest stock market professionals I know. We discussed the economy, earnings, and the outlook for stocks. In the end, we agreed that the stock market has rebounded to a level that fundamentally represents extremely unattractive risk/reward for investors.

To us, it appears that "Sell in May and go away" will once-again be in play this year. This article presents the content of our discussion in interview format.

Before we begin, investors may be interested to know that Pipeline Data's latest Risk/Reward Chart for the S&P ETF (NYSEARCA:SPY) confirms our bearish view. For those unfamiliar, our Risk/Reward Charts marry technical and fundamental analysis into an easy-to-understand visual format. Our last few market calls have proven prescient. To see for yourself, simply CLICK HERE.

We'll see if the streak continues. So far, our latest prediction (which advocated shorting stocks at 2050 on the S&P) has proven premature, but we prefer being a little early than too late in this case.

Getting back to my contact, he's been in the business for about two decades and I've known him for most of that time. Like me, he utilizes a huge network of contacts. However, his contact base differs greatly from mine, which makes us very complementary. Our conversation went a little like this:

Pipeline Data Contact: So let's see. The stock market is trading positively, but trending bearishly. On the long side, I'm tilted towards large caps. If we keep rallying, that's what usually works in a slow growth environment. We're certainly somewhere between slow growth and a recession.

Mark Gomes: Right.

Pipeline Data Contact: I'm not sure if we crash right away or we go higher. It seems a little too easy to say "the rally will hit 2100 and then immediately crash". But that's how it looks, so I wonder how it will be different.

Mark Gomes: My gut tells me we're in for probably two years of volatility (if not pain). Not 2000 or 2008 pain, but the kind of a grinding slow pain we've already endured for the past year or so. I'm following the Atlanta Fed's GDPNow data. It has been a great guide.

Pipeline Data Contact: The guys I've been using have also been doing a good job. They started off calling that we were going to crash in July and now they're saying we're going into recession in the US. I don't honestly know if we're going into a recession, but I know we have slow growth. I think we can go down to 20% from here.

Mark Gomes: I agree and it remains to be seen how that's all going to play out. My ongoing thesis since early-2015 is that there's going to be several years of pain. My latest model shows the fair value in the S&P is probably 20% below where we are right now and it's going basically nowhere for the next two years.

Pipeline Data Contact: One of my contacts keeps calling for a 20 or 30% decline this year. He also points out that we're in the 8th year of a presidential election. This has happened six times. Five out of six times we were down an average of 15% for the year. The fourth year of presidential cycles are usually bullish, but not the eighth year of a term. Also, the first year after an eight year cycle is down.

Mark Gomes: A lot of that is interesting. We've had eight years of stable leadership. You can argue whether it was good or not, but it was stable. But now, we could be seeing some major, if not scary, change. Is it going to be Trump? Is it going to be Clinton?

Pipeline Data Contact: Yeah it's terrible.

Mark Gomes: It's going to scare the heck out of a lot of people, one way or the other. That context makes me feel that the cycle work is more relevant. I don't know who which candidate provides a bullish setup.

Pipeline Data Contact: Nobody.

Mark Gomes: I agree. If you look at the top two candidates in each party you have to assume that one of those top two folks are going to get the nomination in each party and then one of those guys is going to end up in office… and none of them are going to engender comfort among the majority of people.

Pipeline Data Contact: That's right. On another note, since 1940, there have been 12 times when we had 20%+ corrections. Nine of those were 20% to 40%, three of them were 50% or more. The average recessionary decline has been 30%. On the 20% to 40% declines, it takes two years to get back to break even. For a 40% or greater decline, it takes five years on average.

Mark Gomes: Well, we're pretty close to 0% growth now. It won't take much to go negative. More importantly, with slow top-line growth, the big mover has to be operating margins, right? But we reached world record levels of operating margins a year ago. This has to reverse back to the mean at some point… and the mean is 50% below the high. So, even if we don't go into the recession, operating margins still have to get cut. If so, the only way that stocks don't fall is if P/E ratios go even higher than they already are.

Pipeline Data Contact: I'm with you. We've had a very shallow recovery. If we get a recession, I think we get a shallower top line recession, but you have the same margin impact as you always would. Maybe go down 25 to 30%, I don't know. I always thought we would go down -- more through the market structure. Buybacks stall, institutions stop chasing, and stocks get crushed. Maybe we'll even have a flash crash type of thing, forming a "V" panic bottom.

Mark Gomes: Right. People are going to have to reach for yield at some point. That would put a floor under things. As long as earnings aren't falling anymore, we'll at least know what the floor is on yield.

Pipeline Data Contact: Right. Sounds like you're talking about getting down to like 70 or 65 bucks in earnings.

Mark Gomes: Yeah, if we get a recession.

Pipeline Data Contact: Yeah. Cut in half, right?

Mark Gomes: That's a lot. Take a look at operating margins for corporate America and you'll see how much room there is for a downward movement.

Pipeline Data Contact: Yeah.

Mark Gomes: If you look at some of the larger companies that we have out there now like the Google and the Facebooks, and the Apples have all become very large companies, a part of our economy, and all of them are extraordinarily susceptible to negative operating leverage.

Pipeline Data Contact: Yeah.

Mark Gomes: Right? Earnings leverage is great when things are going up because 90% of the revenue goes to the bottom line but when it goes the other way, 90% of the revenue comes out of the bottom line. In an information economy when things go south, they go south hard.

Pipeline Data Contact: Yes, and then the budgets get hit.

Mark Gomes: Right. I'd be surprised if much of what we're talking about is wrong. Gravity will eventually win. There is no way for margins to go up forever, there is no way for the economy to go up forever, and we've got enough problems in the world.

Pipeline Data Contact: The problem is in a low-growth environment, you can continue to have high supply of oil and inventory. That's going to keep oil prices down. The inventory levels are going to just keep rising.

Another thing I think is going to be major here is, if you look at the demographics it's the baby boomers who are retiring now. I just actually spoke to my uncle last night, he wants some money out of stocks, because he's like "My retirement is at risk in the stock market. If I don't lose money from here, I'm okay. I'd rather be ok than risk losing half of my retirement again (like in 2001 and 2008)."

Mark Gomes: Right.

Pipeline Data Contact: Right. He said, "The start of 2016 knocked a couple of years of off my retirement capability. I can't afford that." A lot of people are going to want to seek safety, plus, when you get to a certain age, like these baby boomers are, you start shifting from equity exposure to fixed income exposure anyways.

Mark Gomes: Right. Plus, the first round of boomers are turning 70 1/2, so they have to take withdrawals.

Pipeline Data Contact: Right. It's not pretty and the millennials are the ones that have the ability to cause a setback because they're the echo boom. But their tendency is not to make much money. They're very existential. It's very reminiscent of the seventies in some ways, at least culturally.

Mark Gomes: Yes. Demographically, we're in a similar spot. The 1970s was characterized by the end of the Baby Boom, replaced by a much smaller generation, which put a drag on growth. We have the same thing now, only with the Millennial generation having ended. But birth rates are near all-time lows. Lastly, low interest rates have created a high-competition environment. On the bright side, all the new competition created new jobs. However, I believe that trend is about to reverse, as heightened competition causes weaker businesses to fail, leading to job losses. Not good for the 5-year outlook.

Pipeline Data Contact: Right.

Mark Gomes: So there you have it. Short everything and I'll meet you at the bottom.

Pipeline Data Contact: Haha. A little dramatic, but it seems like the right call.

Disclosure: I am/we are short SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information in this article is for informational and illustrative purposes only and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. The opinions expressed in Pipeline Data, LLC publications are the opinions of Mr. Gomes as of the date of publication, and are subject to change without notice and may not be updated. All investments carry the risk of loss and the investment strategies discussed by Mr. Gomes entail a high level of risk. Any person considering an investment should perform their own research and consult with an investment professional. Additional important disclosures can be found in the Important Disclosures section at PipelineDataLLC.com.