Judging by the dramatic decline in the VIX and the parabolic rise in the prices of many risk assets such as stocks and junk bonds, one would get the impression that the risk factors that provoked a 20% decline in stocks between May and September of 2011 have essentially disappeared.
Have those risk factors disappeared? Or is it possible that investors have become complacent and/or and are overlooking factors and that will once again emerge to dominate investor consciousness and roil financial markets? In this article, I will focus on U.S. domestic risk factors.
1. U.S. Debt Ceiling. The 2011 stock market decline was initially kicked off by fears that the U.S. might default on its sovereign debt. These fears were caused by a stand-off within the U.S. Congress and the Executive branch in which both parties threatened to trigger a U.S. default unless their demands were met. Ultimately, a political compromise was reached that presumably would enable the U.S. to fund itself through the upcoming presidential cycle.
As it turns out, the U.S. deficit is projected to be much higher than expected and the U.S. Treasury will probably run out of money to pay its bills - including principle and interest on debt -- by September 2012. It is clear that the Republican party will have no incentive whatsoever to help President Obama or the Democratic party. Therefore the risks of another damaging stand-off in the late summer and/or fall of 2012 are quite high.
The market is not currently computing the potential risk of another damaging debt-ceiling stand-off. But the risk is there, and it seems likely that it will once again come to the fore to roil markets.
2. U.S. Debt. The debate about the U.S. debt ceiling raised public awareness about the fact that the U.S. public debt is rising to levels that many consider to be alarming. What has changed in the past few months to ameliorate these fears? Has the U.S. debt decreased? As a point of fact, the U.S. debt is currently rising at a faster rate than it was heading into the third quarter of 2011 when stocks were declining. Thus, U.S. debt is a latent risk factor that can and will rear its ugly head at any moment when the public again focuses on it.
3. U.S. deficits. The U.S. public debt is a product of an out-of-control fiscal budget. The government spends too much and collects too little revenue. The U.S. government is currently spending 163 percent of its tax revenue. In other words, the U.S. government is spending 63% more than it collects in tax revenue and the difference has to be made up through increased indebtedness. Right now, the U.S. is adding to its public debt at an absolutely unprecedented rate - roughly 9% of GDP every year.
At this rate of debt increases, the U.S. would very soon become insolvent. The U.S. has three choices, none of which are very positive for stocks.
- The first option is for the U.S. government to continue piling on the debt until the sovereign becomes insolvent. That option is quite obviously bad for stocks.
- The second option is to gradually reduce the budget deficit. This option is better than the first, but it will still be very painful for stocks. Consider: It would take about six years of reducing the budget deficit by 1% of GDP simply to get the deficit to a "sustainable" level of around 3% of GDP. And since there is likely to be a recession at some point in the next six years in which the deficit will certainly increase (due to lower revenue and automatic spending stabilizers), it is clear that in a best case scenario, bringing the US deficit down to sustainable levels will take the better part of the next decade. And during this time, deficit reduction will act as a major drag on economic growth. All things being equal, the long term sustainable rate of real economic growth for the U.S. is generally estimated in the neighborhood of 2.5% per annum. However, it is likely that this growth rate could be shaved by as much as 1.0% per annum for the next decade due to the drag created by the necessary reduction of the U.S. fiscal deficit. This sort of lethargic economic growth would clearly be bad for stocks.
- The third option is for the Federal Reserve to assist the U.S. Government in "inflating" the debt away. Some analysts have cited this possibility as bullish for stocks. However, this speculation ignores historical facts. High inflation rates in the U.S. have been strongly correlated with contracting profit margins, slow rates of real earnings growth and declining PE ratios for stocks. The negative correlation between high inflation rates and PE ratios holds true for the history of stock markets all around the world. An exception could be contemplated for the possibility of rapidly rising nominal (not real) stock prices due to hyperinflation. However, at the present time, this must be considered to be a low probability outcome that can in no way be cited as an explanation for the recent rise in stock prices. If stock prices were discounting a hyperinflation, such expectations should also be reflected in the prices of bonds and other assets. And the fact is that no such expectations of hyperinflation can be found in any asset class (including gold).
In sum, the risks posed by high U.S. budget deficits have not gone away. To the contrary, they are intensifying.
4. Monetary policy risk. Investors have become complacent about the beneficence of central banks to the economy and stock prices. Investors seem to have forgotten a long history of central bank policy blunders (usually though excessive monetary tightening or easing) that have ultimately hurt stocks. In the present set of circumstances, the margin for error enjoyed by central banks around the world such as the U.S. Fed has narrowed considerably. Therefore the probability of error has increased.
In particular, the tripling off the U.S. monetary base in the past three years poses extraordinary risks going forward that the Fed will be hard-pressed to manage without wreaking havoc on the economy. For example, as soon as the economy shows any real signs of strength it is likely that excess liquidity could soon translate into rising inflation. The central bank will then be in a conundrum: On the one hand, the central bank can either slam on the brakes and withdraw excess liquidity at the risk of killing the economic recovery. On the other hand, the central bank can choose to tighten monetary policy too little or not at all and risk a major inflationary episode that would cause even greater economic disruption down the road. Another scenario is that the "bond vigilantes" simply take over monetary affairs via the bond markets - particularly at the long end of the curve - and wreak havoc with interest rates and the overall economy. Any of these scenarios is bad for stocks.
The road to high equity valuations in this monetary environment, is a very narrow one, indeed.
One may wish to bet that the Fed will be able to manage this exactly right. But the risk of a policy misstep in the context of an unwinding of extraordinary liquidity initiatives has not gone away. If anything, these risks have intensified in the past few months with the advent of various new Fed initiatives and LTRO in Europe.
5. Heightened macroeconomic volatility. High debt and deficits create sharp interest rate sensitivity. The reason is simple: The higher the debt, the higher the drag of interest costs on the economy. At the same time, the combination of high interest rate sensitivity and excess liquidity are a recipe for heightened macroeconomic volatility. Why? Excess liquidity raises the risk of interest rate volatility. Higher interest rate volatility, combined with high debt levels, suggests heightened macroeconomic volatility.
What has happened in the past few months to suggest that the risk of rising macroeconomic volatility has been mitigated? No such thing has occurred. Heightened macroeconomic volatility in the next decade relative to the averages of the past three decades is a high probability event.
6. Recession risks. In the view of ECRI and other analysts, notwithstanding recent figures that suggest U.S. economic firming, the risks of a near-term recession in the U.S. have not abated and remain elevated.
My own view is that a recession in the U.S. is unlikely at this stage unless there is an external shock.
However, all reasonable analysts agree that the ongoing U.S. economic recovery is the weakest since WWII. This implies that the U.S. economy is more vulnerable than usual to external shocks that could bring U.S. economic activity below "stall speed." As a result, the risk of a major slowdown or even a recession in the U.S. can by no means be disregarded -- as stock market participants seem to be doing at this moment.
7. Decelerating long-term GDP growth and earnings growth. The drag of high public debts and deficits on GDP growth is an almost inescapable reality. Add household deleveraging (or at least flattening of household debt expenditure relative to past decades) and the potential growth rate for the U.S. slows further. Add a deteriorating demographic profile and growth expectations decline further. Add the impact of higher risk premiums due to increased macroeconomic volatility and growth could be impacted further through the higher cost of capital and concomitant lower rates of investment.
What has happened in the past few months to mitigate the likelihood of decelerating GDP and earnings growth in the U.S. for the next decade? The answer is that no such thing has occurred. Decelerating long-term GDP growth and earnings growth continue to be high probability events. I am not a proponent of doomsday for the U.S. However, it is clear that future GDP and earnings growth in the US will very likely be below trend. This fact is currently not reflected in stock market valuations.
8. Profit Margin Erosion. S&P 500 (SPY) profit margins have almost certainly peaked. There was a marked deterioration in margins in the fourth quarter of 2012. Margins are expected to shrink throughout 2012. Earnings growth has also decelerated from double digits down to 7.8% year over year [2.7% without Apple AAPL)]. Even in the technology sector, earnings growth has decelerated significantly to just 3.3% year over year ex-Apple. The rate of estimate revisions point to further downside.
At this point, It is only a question of how much margins will shrink and how much earnings growth will decelerate, not whether this will occur. Historically, peaking profit margins and decelerating earnings growth has been associated with market tops and sub-par equity returns. Will it be different this time?
In my next article I will highlight various risks to the U.S. economy and stock market that come from outside the U.S. However, it is not necessary to go abroad to appreciate the fact that the U.S. equity market faces extraordinary risks. These extraordinary risks are not priced into the market.
How does one know? There are many ways to gauge this. One way is simply to look at implied volatilities (^VIX) and sentiment surveys. Perhaps the most objective way is to look at valuations. Whether you use Shiller's PE10 or any other metric of normalized valuations, U.S. indexes such as (^GSPC), (^DJIA) and (^IXIC) and index ETFs such as SPY, DIA and QQQ are currently trading at valuations that are above historical means. In the current environment in which future growth prospects are below historical means and future volatility prospects are above historical means, normalized valuations should be below historical means. Therefore, U.S. stocks are not only not pricing in extraordinary short-term risks; they are not pricing in the most probable long-term outcomes regarding below-trend growth and above-trend volatility.
The sentiments that drive perceptions are volatile and move in cycles. In this case, the fundamentals have not followed sentiment and, if anything, have continued to deteriorate. The implication is that U.S. stocks are vulnerable to suffer major declines as soon as the aforementioned risk factors regain prominence in the public consciousness.