Headwinds, Tailwinds: On The Bear Side Of The Debate

by: Macro and Cheese

My father was an aircraft engineer and small plane pilot, and is a lover of all things related to aviation. Every time we fly on a commercial plane together, he mentally rates the landing, taking into account wind speed, visibility, the approach, and the runway. I'm always amused to hear economists talk about "hard landings" or "soft landings," because unlike a real plane we're not going to land at all. We're going to stay right up here, in the air, negotiating the currents.

If we know the flight conditions, we can fly the plane. I'm fully convinced that economic fundamentals determine market prices over the long run, and to a greater or lesser extent over the medium term as well. If I can get the fundamentals right, the only obstacles I face are the short-turbulence of the market, and my own psychology. I can tolerate the bumps by sizing my positions to withstand some bounce. I don't let risk get concentrated.

That leaves my own psychology. I have to accept the natural tendency to see what I want to see. If I'm bullish I'm going to downplay a bad employment number or retail sales disappointment. To counteract that bias I read opposing research, and identify as many counter-arguments to my own opinions as I can. What counts is not what I think, but what the market does. Stubbornness can be very expensive.

With volume at recent lows and yet mid-term S&P options still expensive, uncertainty is high. This is a great time to review the bull and bear arguments to decide whether a larger commitment is warranted. Is it time to buy the dip, or sell the weakness?

Tailwinds

--Stocks are cheap. With trailing price to earnings at 13, an investor receives an 8% return on his invested dollar. This return is high enough that investors have a nice cushion in case something goes wrong. Because the "carry" is so high, it is expensive to short stocks, providing another protective layer to stockholders. The short seller has to have his timing right, because the clock is working against him.

--Interest rates are low. This to me is the most compelling reason of all. It's one thing to get an 8% return (historically not so unusual), but it's another when your opportunity cost is effectively zero. And because inflation generally goes in lockstep with that opportunity cost, about 2/3 of that 8% return is a "real" rate--the return after inflation. The Fed tells us inflation will remain low, and indeed Bernanke's oft-cited inflation gauge, TIPS-based breakeven "5-year inflation 5 years forward," is a benign 2.5%.

--Dividend yields are very competitive with bonds. At 2.03% as of yesterday's close, the S&P 500 dividend yield is about the same as 10-year treasury bonds, and much higher than CDs or other time deposits. Dividends have been increasing in size and are slated to do so into 2013 as corporations look to pay out some of their excess cash.

--Companies are financially healthy. The financial sector is stable and profitable, and corporate cash levels continue to grow. Firms of the S&P 500 are sitting on nearly $1trillion, or about 11.5% of the index's market capitalization as of January 30, according to Reuters.

--LTRO and other measures have stabilized Europe, and China expects growth of 7.5% this year--down from its norm, but still stimulative, coming from the world's second largest economy. These centers are critical to US commerce. Both regions are expected to slow relative to last year, but the price to earnings cushion will act as a buffer against any decline in earnings.

--The residential real estate market has stabilized, and interest rates will support home prices into the future. The most recent housing report showed 699,000 starts, up from the April 2009 low of 476,000 and 100,000 higher than six months ago. Builders are more confident, and stocks such as Toll Brothers (NYSE:TOL) and Home Depot (NYSE:HD) are flourishing. Thanks to low prices and rock-bottom interest rates, homes have rarely been more affordable.

--Unemployment and consumer confidence are both improving significantly. They're at or near the best levels dating to the beginning of the 2008 economic crisis. These factors should give a boost to consumer spending, famously 70% of the economy, and also help to turn around the real estate market, a significant contributor to jobs and growth.

--Retail participation in the rally has been minimal, but with interest rates so low, individual investors may be tempted to re-enter the market and could take stocks up to higher levels.

Headwinds

--After a decade-long borrowing binge, consumers are curbing their consumption and repairing their balance sheets. Although about 15 percentage points below the peak 130% debt to disposable income level, American consumers have a long way to go to get down to sustainable levels. Doing so will not be easy. Disposable income has not increased since 2006 in real terms, and currently 11% of that goes towards debt payments alone.

--The US government has been borrowing and spending at a rate not seen since World War Two. US government debt to GDP won't be far from 100% this year. The rest of the world is no better, with Eurozone debt to GDP approaching 90%, and Japan's now well over 200%. Austerity measures are being implemented in Europe and Japan, and are now being floated in the US. These will reduce US exports through a general reduction in demand.

--That export demand will be further weakened by a strengthening dollar. Since hitting its low last May, the dollar has risen by about 10%. We have seen the results, with net exports trending downward. A higher dollar raises the price of US exports, creating a competitive disadvantage. The stronger dollar also reduces the value of non-dollar revenues from offshore operations, the opposite of one of the tenets cited by bulls when the dollar was weakening.

--China growth is sub-par and will remain so for some time, as Chinese wages rise and as their real estate bubble bursts. Although the projected 7.5% growth rate is high compared to most of the developed world, this is down significantly from China's 10% average. China is suffering a "growth recession."

--At $2.9 trillion, the Federal Reserve's balance sheet is about 20% of GDP. The Fed's holdings consist primarily of US treasury and mortgage bonds bought in conducting QE operations. When these bonds are sold to unwind the stimulus, interest rates will rise, and cash will leave the system, dragging down growth as a result. Although the Fed is in no hurry, this unwinding is inevitable.

--The one-year trailing price to earnings ratio is reasonable, but the longer-term Shiller P/E ratio of nearly 22 sheds a different light on that metric. Shiller's ratio sums earnings over the past ten years, so we can expect a higher ratio in general, but even so, 22 is historically very high, as Shiller himself points out. The Shiller P/E ratio is designed to take into account the cyclical nature of margins. Since earnings have been at historically high levels, supporters of the Shiller number claim it to be a more accurate assessment of equity valuation.

--Although improving, unemployment will remain high, as will underemployment. The housing bubble masked a structural unemployment rate that is significantly higher than the 5% rate of last decade. Unemployment may continue to decline, but we will not reach the lows that marked the peak in 2007.

--Global demographics in general, and US demographics in particular, are not supportive of stock prices. Baby boomers are retiring and will begin to draw down savings, and the population is not growing fast enough to support the aging population.

--Oil prices have been rising steadily and gasoline is breaching $4 per gallon. Between higher gasoline prices and debt payments, Americans have substantially less disposable income to spend, especially with stagnant real wages.

Verdict

As you can see in the disclaimer, I'm weighing on the bear side of the debate, with a caveat. This strikes me as a peculiar moment in financial history. Investors are effectively asked to weigh the immediate facts on the ground against the theoretical. The facts are the economy is growing, and given interest rates, return on capital is relatively high. In theory, on the other hand, the headwinds are formidable. For the moment, they're just not on display. In this environment, stocks will rise when there is good news, no news, or even mildly bad news.

Why then be bearish? Primarily because I don't see how the negatives cannot drag GDP down to a level that pulls earnings down to earth. The government bailouts - and there have been so many - come with a price, and on that front we have yet to make even the first payment. Facing similar obstacles, Japan has scarcely grown at all over the past 20 years. The US may avoid two lost decades, but it's hard to imagine us dodging one. So I am short, though it's not my favorite environment for it, given the cost of carrying the position. I will add only on a market downturn.

If I've left out your favorite bull or bear argument, please, include it in the comments section.

Disclosure: I am short S&P and Dax futures.