It's October - Should We Be Buying?

I recently enjoyed watching Evan Almighty with my family. For those not familiar with the sequel to Bruce Almighty, Evan, played by Steve Carell, has left his anchor position after being elected to Congress. When he arrives in Washington, God gives him subtle and then not so subtle signs that he should build an ark. Of course, this modern-day Noah becomes a laughingstock as no one, not even his family, can understand his grave concerns. Well, here we are in October, traditionally a great time to buy stocks, and I can relate to Evan. While my observations to follow aren’t divinely inspired, I do sense a great flood of sorts is upon us.

As background, I am not one of those perma-bears or a pessimistic person by nature. As a former mortgage trader, I have always had a keen interest in that market, and I had watched for a couple of years in amazement while the credit standards were degraded. It wasn’t until the summer, though, when I finally believed that we had reached a tipping point with respect to the economic impact that the housing bubble would have. In a companion piece that I wrote today, I described how the post-Fed easing has resulted in an unsustainable rally. In this article, I hope to clearly explain how I think the coming economic crisis will unfold.

In the summer, we experienced a financial crisis, with the mortgage market grinding to a halt and subsequently leading to the commercial paper markets to implode. The ripple effects, which still continue despite several Fed interventions and jaw-boning, include trouble funding LBOs. Several deals have already been cancelled. While the crisis has abated, at least for now, the impact on the economy has just begun. Credit is the grease that makes the economy run, and standards are tightening across the board. The impact on the consumer, already in a tough position in recent years due to high levels of debt, increased energy costs, rising property taxes, soaring college costs and stagnant wage growth, is the most significant.

Since the housing market peaked, credit growth has been expanding more rapidly than retail spending. While the credit growth has been strong and steady, consumer spending has been rather muted, begging the question of what happens as credit availability shrinks. In the last recession, the consumer remained much stronger than expected (thanks to the cash-out refi and perhaps a bit of “spend it now” mentality post-9/11). Is it reasonable to assume that the consumer has become permanently immune from slowing discretionary spending? A weak housing market which is likely to remain weak in many markets due to high prices still will not bolster consumer confidence. Even in more normal markets, the shrinking of credit and the high supply of inventory along with the bombardment of negative headlines could serve to constrain consumer spending. This, of course, doesn’t even include the ratcheting up of principal and interest payments for those unfortunate exotic loan borrowers.

All year, the pundits have disregarded the consequences of the turmoil in housing, as the impact has been consistently underestimated. What started out as just a small portion of the market has been shown to be a much deeper problem. Investors want to believe that this too will pass, but those who have tried to time the bottom have learned. Witness the bottom-fishing attempts that have failed in housing stocks and in the financial sector. Of course, worse than Financial stocks recently have been the Consumer Discretionary stocks. How much longer until investors realize that ultimately all stocks will be impacted?

Clearly the “global” theme continues to excite investors. Is it safe to assume that those companies that sell outside of the U.S. are somehow safe havens? Notice that the stock exchanges of the developed world have not yet recovered their highs. From a longer-term perspective, both the U.S. and the foreign markets have essentially a double-top. Is it reasonable to expect that we can just devalue our currency indefinitely and export our way out of trouble? Even looking at the torrid BRIC stock markets and their underlying economies, is it reasonable to expect that in a time of tightening credit that these countries will continue to have access to so much capital? For those who want early signs of the global economy potentially cracking (beyond looking at the foreign stock charts), the reports last week from Industrial companies, especially from Caterpillar (CAT), certainly weren’t encouraging.

As I think about how a full-blown consumer recession plays out, it is unclear to me what the policy responses from our government will be. In terms of expectations, it is clear to me that stocks will head lower, but bonds and commodities depend on our monetary policy. I believe that cutting rates aggressively could hurt bonds in the short-run and help commodities as the dollar gets crushed, but ultimately bond-rates will come down and commodities will languish amidst slower global demand. If the Fed, in realizing that rate cuts aren’t effective in dealing with the housing problems and excessive debt problems, is more measured in its monetary policy actions, bonds will likely perform exceptionally well.

Looking at stocks, there are really just two things that impact the valuation – the earnings growth and the required return of investors. I am negative generally on earnings growth as I believe that many of the sources of growth in recent years are dissipating: Leveraging balance sheets to repurchase stock, productivity improvements and outsourcing to India and China are all relatively mature. The low-hanging fruit has been harvested. If one looks at margins across the S&P 500, they are very high historically, especially when one considers that they now include options expensing. Further, in a slower growth or recessionary environment, earnings are harder to grow as well. We are in our sixth year of EPS growth for the S&P 500, which is unprecedented in recent history. In fact, they are expected to rise yet again next year. In the last recession, EPS fell sharply and quickly, while in the early 90s they fell something like 10% per year for three years. The required return is a function of two things: the risk-free rate and the risk-premium. While I believe that there could be downward pressure on the risk-free rate, it is likely to be offset by a higher risk-premium. Stocks, broadly speaking, are pretty “normal” on a PE basis. I expect that the E will be more of a driver than the P/E. As you can see in this long-term chart, the trailing PE of 18X is fairly average, though the dividend yield, despite recent improvement, remains low. Adjusting for the low level of interest rates makes stocks look a bit cheaper. My call is not one of excessive valuation but rather one of being time for a big drop in EPS.

I believe that the recent recovery in the market may have convinced some that the problems from the summer have passed. It is worth noting that the slight extension in the DJIA and the S&P 500 was not met by the broader market, as the Russell 2000 failed to recover its July highs. Additionally, volume was very light. As mentioned above, Germany, Japan and the UK didn’t make new highs either. With the big drop last week, the R2000 closed below its 200-day moving average. As you can see in the chart below, the index, which represents the stocks smaller than the top 1000 stocks, looks to be under pressure. Traditionally, large-caps do better in a slowing economy. They also tend to benefit from a weaker dollar.

Finally, I would like to conclude with a series of charts on stocks that I think say a lot about important segments of our economy and how the problems don’t appear to be fixed.

Freddie Mac (FRE), the conforming mortgage market:

Countrywide (CFC), the largest mortgage lender:

Wal-Mart (WMT), where Joe Consumer shops:

Merrill Lynch (MER) (I have predicted 50 before this is over):

Large-Cap Financials:

Large-Cap Consumer:

Homebuilders – making new lows despite the Fed ease:

So, I am building my ark, betting that finally the consumer succumbs to his high debt burden. Like an alcoholic, he was never going to give it up, but it looks like the bar-tender is calling for the tab to be paid up. Without the enablers, the consumer will retrench. The Financial and Consumer stocks probably still have some downside, but the real opportunities for price declines are in those sectors where investors mistakenly assume that there is safety. This next year could be very interesting – a slowing economy, a weak stock market and a Presidential election. My call: 1150 on the S&P 500 a year from now, a decline of over 20%.

Disclosure: No position in any stock mentioned in this article

Comments

[bond investor:]

Alan, very cogent analysis, as I'd expect from a fellow CFA charterholder. You lay out your reasons for bond bullishness, but don't cover the scenario in which commodities would do well. Since you like bonds if the Fed doesn't cut "too much," I'm guessing that you'd prefer commodities if they cut "too much" and take us down a stagflationary road instead of a recessionary/slow-grow... inflation or even deflation road.

Rather than looking at the Fed, I would look at the Asian and Middle Eastern central banks and sovereign wealth funds, since they own and buy far more debt than the Fed. They'll tolerate currency declines in their U.S. holdings only for so long.... perhaps until just after the Beijing Olympics. At that point, look for weak U.S. demand to be exported to the rest of the world.

2007 Oct 24 11:58 PM

[Alan Brochs...:]

I agree with your point - I even thought about bringing up that term stagflation. It has been quite some time since we experienced what is the worst of all worlds when it comes to the economy. Also, as you point out and I have mentioned in other articles, the Fed truly isn't the one to watch any longer. The world is more connected than ever.

2007 Oct 25 08:41 AM