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U.S. Stock Market Appears Expensive, Caution for Equity Investors: Focus on Sentiment & Risks

 In our previous posts, we (1) reviewed the valuation of the Market based on CAPE and forward operating earning estimates for the S&P 500, which are two indicators that provide a general estimate that the Market appears expensive; (2) we noted that our anecdotal evidence indicates that there are fewer undervalued companies in the current environment, and in some cases free cash flow is not keeping pace with earnings; and (3) we analyzed investors’ sentiment and how investors are focused more on returns than risk.

Sentiment Continued: Banks Market Forecasts Bullish

Although we previously wrote and covered current market sentiment as being bullish, some of the banks since our last writing have posted their 2011 target levels for the S&P 500 and we’ve decided it was appropriate to cover these in this piece.  These 2011 S&P 500 target levels are as follows: (1) 1,450 from Goldman Sachs, approximately a 20% return from current levels; (2) 1,400 from Merrill Lynch; and (3) 1,325 from UBS.  As one can already guess, we believe these targets to be extremely optimistic, especially considering the topics discussed earlier.  In general, these forecasts dictate that the markets will rise on real gross domestic product growth (“GDP”).

Assuming their forecasts for GDP are correct, there is no guarantee that the Market will react positively to GDP growth.  Often lost in these forecasts is the fact that there is a weak – at best – positive correlation between GDP growth and long-term stock market returns.  There are many explanations for this, one being that GDP resembles a total sales number and does not represent corporate income.  Stock prices are usually linked to earnings and earnings expectations.  Historically, due to various operating and financial leverage corporate profits tend to fluctuate much more than GDP, making GDP a poor link for corporate profitability.  Furthermore, once reported GDP is a historical number, while stock prices are based on future expectations of performance.  For those who wish to read more into this topic, we recommend the following external source from Virtus.

When we focus on macroeconomic issues, our focus is more on the impact these issues will have on corporate profitability, confidence, and other psychological forces within the market.  During a bullish period, bad economic and stock news can be ignored or forgotten the next day.  Yet, if the news is of such magnitude that people suddenly realize their expectations for the future were too great, then panic or fear can take hold and trigger downward pricing pressure.  As we’ve told many people, understanding finance and valuation is important, but – more so – is the ability to hone into those situations where psychological market forces present clearly undervalued opportunities.

These targets are just another example of the current bullish sentiment in the market that focuses on returns and not the risks.  To be fair, these banks did state that there were some risks that could cause the Market to significantly underperform their targets; however, they did not quantify that risk or adequately present it to the investor.  All the investor, or the public, sees is the bullish price target.  If the banks felt strongly about these risks, they would have showed up in the price target.  Considering that the price target tends to be calculated as an expected number from various scenarios, these risks were probably already quantified in the reported target.  If that is indeed the case, then just imagine how bullish their best case scenarios are: probably ranging from 1,500 to 1,700?  That would be one large rally.  In such a rally earnings would most likely have to continue to beat what are looking to be increasingly hopeful estimates.

As a point of preference, we prefer to eschew the use a single price target level.  Instead, we will always use a range of value, since value is never confined to a single price point when considering the uncertainty that always accompanies the future.  Furthermore, the range will allow our readers to see exactly what our thoughts are of upside and downside potential of an investment.

Potential Risks to the Current Market

Despite our case that the Market is expensive and its participants tend to be very bullish, we do not believe that the Market is just going to drop one day.  There usually needs to be a trigger, or a catalyst, that causes people to question their current method of investing and induces emotions opposite of greed.

Over the course of the last few weeks we have built a list of such items that could potentially trigger a downturn if they are to materialize.  These issues should not be unfamiliar to many of you as they tend to take turns having their 15 minutes of fame, yet some have been ignored for quite a while.   Due to the fact that some of the systemic risks to worldwide markets that existed in 2007 and 2008 remain unresolved, a large portion of these items are linked to each other.  We are not putting a timeline on these risks, but believe that some of them could materialize within the next year or two. As expectations for corporate performance continue to rise, we believe that the magnitude of the shock required to cause a downturn in Market prices from any of the risks below becomes less.  The list of our items, which is not an inclusive list, is as follows:

(1)     Municipal bonds. Many state and local governments are in bad shape from a fiscal perspective and as time passes they may struggle to properly service their outstanding obligations.

(2)     Premature fiscal consolidation. Historically, austerity measures and a reduction of fiscal stimulus before the economic recovery can stand on its own, results in downturns in both stocks and the economy.

(3)     Continued growth of the fiscal debt. While we recognize the importance of fiscal stimulus, the growing debt of the U.S. has been a concern to some since 1990.  A nation developed nation has proven that it can hold a large debt burden for some time, but are we to believe that the U.S. can endlessly issue debt without any consequences.

(4)     Defaults of junk bonds. Such an event could cause both equity and debt investors to rethink the presence of risk in their investments.  Especially if a number of the companies that default are publically held companies.

(5)     Commercial real estate weakness lingers. With the commercial real estate market still weak and facing continued weakness, there are approximately 350 banks between the sizes of $1 billion and $10 billion with unhealthy exposure to commercial real estate.  In all, there are approximately 2,950 banks with significant exposure to commercial real estate.  Many write downs have been withheld, but that cannot continue indefinitely and many defaults and write downs are likely. For more information, see COP report.

(6)     Consumer is still deleveraging and unemployment remains high. Remember the U.S. consumer isn’t just a target market for U.S. companies but also for many of the exporting countries.  Reduction in credit and spending does not occur overnight.  We must remember this is acts as a constraint on future sales growth for companies across the world.  Especially if, other countries’ consumers fail to replace the potential slack of the U.S. consumer.  The only way a society remains highly levered is if it is able to maintain a great rate of growth, the U.S. has not demonstrated that ability yet.

(7)     Trade imbalances remain unresolved. Trade effects the direction of cash flows and the growth of many economies.  The persistence of these imbalances or a sudden reversal in them could potentially have negative effects on the profit maximizing behavior of many companies.

(8)     Overheating of emerging markets. If emerging markets fail to continue to grow or all remain too dependent on the export model for growth, cash flows may leave their countries and trigger sell offs in their markets and currencies, thus destroying a portion of the wealth they created in the last couple of years.

(9)     Rising commodity prices. The price of raw materials and commodities continues to increase – in general – and is beginning to hit manufacturers located in Asia and China.  Some believe that these increased costs will soon be passed on to retailers who have struggled to pass on prices to the consumer.  These increases could significantly hurt margins and reported earnings.

(10) Continued housing market weakness. This weakness affects consumers spending behavior as well as could continue to negatively impact banks, especially with the foreclosure issues that have recently come to light.  Continued weakness may be enough to slow down the economic recovery.

(11)  Long-term decline in oil production. Recently, the International Energy Agency reported that production at current fields is in decline and that by 2035 today’s active fields that are producing 70 million barrels per day will produce less than 20 million barrels a day.  While this problem is in the future, any recovery that leads to the pick-up in oil demand could be constrained by oil and other energy prices.

(12) China. China, like the other emerging markets, is overheating.  Well, one could argue it has been overheating for years.  The fact that this economy has not faced a major decline yet is not a reason to assume that it won’t in the future.

(13) European union and fiscal debt issues. As the economies of nations continue to be more interdependent, the more at risk the U.S. is to shocks across the world.  Europe is embarking on fiscal austerity measures, while facing challenging times for the euro, these problems do not look good for aggregate demand and the countries that export to Europe.

(14) Currencies and fiat currencies. The currencies we use are based primarily on confidence.  If at any time that confidence begins to erode, then companies will have significant problems to address, not to mention the crisis that would likely be sparked in the markets.

(15) Credit default swaps. This market still lacks proper regulation and – due to its size- could multiply the negative effects of any of the above issues.

(16) Unintended or intended consequences of quantitative easing. While there is much misinformation and uncertainty regarding, its actions have consequences which include the rising of commodity prices and a large amount of reserves sitting at the banks.  These consequences could potentially threaten the profitability of companies and the confidence of the consumer.

(17) Below expected earnings. This is a real threat to the market especially as expectations rise as headwinds still persist.

 

Going forward in the next few weeks and months we will spend some time analyzing and researching these topics with much more depth as we try to better understand the impact they can have on investors’ returns.

Actions Going Forward

At this time, we believe that the Market will most likely behave as it has during past major downturns, which means it will enter into a period of range-bound cyclicality.  Unless companies manage to grow earnings at a record pace for the next five years, we do not expect the Market to march continuously higher as it did during the 1990s.

In our opinion, at present, the Market has much less upside than downside.  Thus we believe an investor should: (1) hold a significant cash position; (2) implement a selective investment process; and (3) be patient.  These three steps should adequately help prepare one for any outcome that occurs in the Market.  We think that it is wise to be cautious and begin augmenting one’s cash balance by liquidating a portion of his equity allocations.  Despite our view, we have not, personally, gone into all cash – there is always the possibility that our current Market view is wrong.  Yet, as discussed earlier, cash provides one with options and can be an effective hedge against a downturn.  Yes, the cash may not be earning a return for you while it’s in the form of cash, but you will be protecting it from investment losses, which is more important.  Remember multiple years of stock returns can be wiped out in a rather short period

As always, we are being very selective of our investments.  We will not overpay for a company, or pay for a company that does not offer significant protection against market shocks in the long run.  Consequently, many of the companies that we review are quickly removed from consideration.  Yet, there are still a few opportunities and we will continue to search for these.  Even in a bullish environment, market forces can turn against good investment opportunities.  We will wait patiently for such opportunities.  We are not going to force investments for the sake of keeping up with the short-term returns our peers are posting. Due to our selective approach, we feel comfortable maintaining our equity allocation.  If the Market continues to climb higher, then we may farther liquidate our equity holdings.

Patience is essential to successful investment from a value-oriented style.  The key to investing during this period is to not force anything.  If we are correct about this Market entering a period of range-bound cyclicality, then one may not have to wait much longer to deploy their cash into good undervalued opportunities.

Over the next few weeks and months, we will continue to flesh out our view of the macroeconomic risks that exist, while also searching through many companies for truly cheap investment opportunities.  We look forward to continuing to post our research and opinions for your consideration.  If you’ve enjoyed our work please feel free to pass on to friends and family.

Best regards,

Chain Bridge Investing



Disclosure: No Positions