In between inspecting my kids' candy cache for "safety reasons," which is parent code for eating the Snickers bars, I read an interesting piece by Simon Constable via U.S. News. He starts out by stating:
"Believe it or not, there are still reasons to be bullish on stocks, and not just because pundits keep showing their angst on business TV. (They are often wrong.) Here are some key points for investors to consider."
Simon goes on to detail six reasons to be bullish on stocks:
Global economic growth to improve
More monetary interventions overseas (QE)
Earnings recession not as bad as you think
Sentiment is bearish
Labor market is improving
Low energy prices to rescue the economy
While these are certainly reasons to be "hopeful" that stocks will continue to rise into the future, "hope" has rarely been a fruitful investment strategy longer term. Therefore, let's analyze each of these arguments from both perspectives to eliminate "confirmation bias."
Global Economic Growth To Improve
Simon quotes Jeffrey Kleintop who states:
"The biggest focus is, 'What is global growth next year?' And some are worried that it's slowing. But forecasts seem to be optimistic. They (the IMF) are better forecasters than the central banks."
That statement is really a subject of interpretation. As shown in the chart below, economic forecasts are generally just about as wrong as weather forecasts.
While the IMF, along with every central bank, are eternally optimistic that economic growth will return, each year has been an ongoing disappointment.
For investors, the problem is that now almost seven (7) years into an economic recovery, real economic growth, and inflationary pressures remain absent.
It is the very lack of economic traction that leads to Simon's second point for the bulls - more liquidity from central banks. To wit:
"Just as loose monetary policy in the U.S. helped boost stocks, the same is likely overseas. The economies of Japan and the eurozone are both sluggish, and it seems that both the European Central Bank and Bank of Japan will continue their so-called quantitative easing plans. Earlier this month, ECB President Mario Draghi hinted that there could be even more stimulus on the way."
There is little argument that "QE" programs in the U.S. boosted domestic asset prices. But there has been little evidence since the start of the ECB's own "QE" program that such benefit has been seen.
The problem for the ECB, unlike the Federal Reserve, is that QE does not have the same migration of liquidity bank into the financial markets due to the fragmentation of financial markets across countries.
However, the real question that must be answered by investors is given the failure of "QE" programs to translate into actual economic and inflationary increases, what is the real efficacy of these programs this far into an expansionary cycle?
Of course, it is the continuation of "QE" programs that is the most telling. If the economy were indeed supportive of higher asset prices, then "QE" programs would not be needed. The question for the "bulls" is what happens when the deviation between asset prices and actual underlying economic activity is realized?
Earnings Recession Not That Bad
"On the surface, U.S. stocks appear to be in an earnings slump. An analysis by PNC of the first 58 stocks reporting third-quarter earnings showed earnings are down 4.6 percent from last year, and revenues are down 3.2 percent. But when the energy sector is excluded, earnings and revenues are up 2.8 percent and 2.4 percent, respectively."
This is a common argument as of late for the bulls - "If we just exclude everything that is 'bad,' then what is left is 'good.'"
No kidding. The problem with that kind of analysis is that it obfuscates the impact of a sector on the rest of the economy. Energy is a good example.
The decline in energy prices is obviously bad for the energy sector. However, it also impacts all the industries associated with the energy sector such as manufacturers, suppliers, and transportation. The decline in energy prices also impacts future capital expenditures from the energy sector which makes up nearly 1/4th of all planned CapEx in the U.S. As layoffs and terminations increase, most likely beginning in earnest in 2016 as oil price hedges expire, then retail and service sectors begin to be impacted.
The point here is that separating out one sector of the economy to make a "bullish" argument is dangerous as it ignores the inter-linkages of the economy as a whole.
More importantly, profit margin recessions and earnings recessions are two entirely different things. As I discussed just recently:
"The 1998 'profits recession' did not immediately result in an economic recession and coincident 'bear market,' it was merely postponed as the market 'melted up' in the midst of the 'dot.com' bubble. In the short-term investors made gains, but the subsequent collapse wiped them out and more.
Secondly, while there was a 'profits' recession in 1998, there was not an 'earnings' recession. As shown in the chart below, earnings (both operating and reported) remained stable."
While ongoing central bank interventions may continue to boost asset prices and create the illusion of the "1998" scenario, it is likely that the "bulls" will once again face a similar fate.
Sentiment Is Bearish
"Sentiment about where stocks will head next is at extreme levels, according to a recent report from investment bank Goldman Sachs. The report shows that on a scale of 0 to 100, investor sentiment about stocks in the Standard & Poor's 500 index stands at just 10.
This is one of those cases, however, in which bearish sentiment is actually good for stocks. Institutional asset managers and leveraged funds are "lightly positioned" in the market, Goldman says, suggesting that there will be near-term upside in the S&P 500. This is what's known as a contrary indicator."
While that statement is true, it is a very short-term indicator more useful for trading rather than investing. In fact, by the time Simon's article was published, much of the "bearish" positioning had already been reversed. To wit from JPM (via Zerohedge):
"In all, while balanced mutual funds and risk parity funds are the ones which appear to have triggered the equity rally since the end of September, the rally was amplified at around mid October by CTA capitulation. The reversal of CTAs equity exposure from a short to a long position means that all four sectors, CTAs, Discretionary Macro hedge funds, risk parity funds and multi-asset or balanced mutual funds, are currently long equities."
The problem for longer-term investors, swings in "bullish" and "bearish" sentiment extremes are only useful when extremes in sentiment are coupled with an overall "trend." As shown in the composite sentiment index (individuals and institutions), the overall trend in sentiment is much more important than the short-term swings in sentiment.
Labor Market Is Improving
Hopes of a continued improvement in employment and wage growth have been primarily just that - "hope." While Simon points to falling jobless claims and the unemployment rate as a potential "bullish" underpinning for stocks, the reality has been substantially different.
The primary push of employment growth over the last six years has been the increase in population that has created incremental demand for employment. The lack of aggregate end demand has kept hiring from exceeding the rates of population to a degree to substantially reduce the lack in the labor force, leading to a high number of individuals being "no longer counted."
However, as I discussed just recently, even the Fed's own bullish measure of employment (Labor Market Conditions Index) has recently begun to deteriorate.
With the current economic expansion already extremely long by historical standards, deflationary pressures on the rise and corporations battling a "profits" recession, employment is likely at risk in the months ahead.
Low Energy Prices To The Rescue
The last hope of the "bulls" has been that lower energy prices will result in a boost to consumer spending. The theory has been that "savings at the pump" will translate into consumption elsewhere.
The problem is that "reality" can be far different than "theory". With the majority of Americans still heavily indebted, wage growth weak and the cost of healthcare sharply on the rise, any excess savings "at the pump" are diverted into "making ends meet."
Of course, a look at a chart of the annual growth rate of retail sales shows you the real problem:
What Should You Do Next
While Simon does clearly note that "investors should not instantly buy stocks," investors should carefully consider how they invest next.
With the current bull market already up more than 200% of the 2009 lows, valuations elevated and signs of economic weakness on the rise, investors should be questioning the potential "reward" for accelerating "risk" exposure currently. As I wrote just recently:
"Ultimately, stocks are not magical pieces of paper that provide double-digit returns over the long run. In fact, we've just had a 15-year period of lousy (less than 5% annualized) returns, and it all has to do with valuation.
While Wall Street and the financial media continue to push individuals into the casino to increase revenues, what is ultimately forgotten is that stocks are ownership units of businesses. While that seems banal, future equity returns are simply a function of the value you pay today for a share of future profits.
The chart below shows that rolling 20-year returns from current valuation levels have been substantially less optimistic. After fees, taxes and inflation, it is substantially worse."
The point of this missive is not to "knock Simon" for his views. What is important for investors is to understand each argument and its relation to longer-term investment periods. In the short term, many of Simon's points will likely be validated as current momentum and bullish "biases" persist in the markets.
However, for longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. As Howard Ruff once stated:
"It wasn't raining when Noah built the ark."