The Bullish Stars Are Aligned
- The Eurozone: Tangible progress in drafting a credible plan for the European debt crisis has started, and though this is not a permanent solution, a flawed plan is better than no plan at all. While stress points remain, crucial details are yet to be worked out and the likelihood of a European recession is high, systemic risk has been removed, and Thursday's decision to lower interest rates by the ECB further supports intermediate-term stability in the region. I am growing more confident that, in the fullness of time, more permanent solutions will follow the current strategy (and the bailout's first step) of monetization and leverage. After all, the alternative is unimaginable for the eurozone economy's longer-term health.
- The Political Theatre in Washington, D.C.: While a grand bargain in the U.S. (one that raises the Social Security retirement ages, raises the tax burden on the very rich, deals with the mortgage overhang, cuts the defense budget and eliminates the fiscal drag of 2012) is not likely, the super committee is now being forced to address the dual objective of assisting in generating economic growth while dealing with our fiscal imbalances. While I am not holding my breath, there have been press reports that some Democrats and Republicans might compromise on tax increases and entitlement spending cuts. We will know soon enough, as the super committee's deadline to submit its plan to Congress is only about two weeks from now. I am hopeful that the super committee and the rest of our political leaders have ;learned from the August circus in our nation's capital (that led to a plunge in confidence and in our equity markets) and will take some decisive steps to rise above their partisan interests.
- The Domestic Economy: The weakening business and consumer confidence that appeared in August have not impacted the hard economic statistics in the fall, and concerns of a recession next year have receded. High-frequency economic data -- for instance, the regional and national ISMs, jobless claims, leading indicators and retail sales (among other indicators) -- are not at all consistent with recession. A market-friendly Fed (sticking with a policy of low short-term interest rates as far as the eye can see) should be supportive of moderate growth of about 2% over the next several quarters. With wage growth contained, 2012 corporate profits will continue to be elevated well above the level that many have feared would be the case earlier this summer.
"Most people get interest in stocks when everyone else is. The time to get interested is when no one else is." -- Warren BuffettBesides the formation of a preliminary eurozone agreement and strategy, the forced agreement by the super committee in November and better high-frequency economic statistics, I see negative sentiment and reasonable valuations as a plus for stocks. The downgrade in economic expectations (back to a more realistic view) and the combined impact of the eurozone debt contagion, the circus in Washington, D.C., and the U.S. debt downgrade over the course of the year have been accompanied by a souring in investor expectations, which is a necessary reagent to a better market. As I mentioned earlier, the major indices have exhibited little movement since the beginning of the year. More importantly, the S&P 500 sells at the exact same price as it did in December 1998 (13 years ago). As a result, I do not feel as though I am paying up for stocks today. In 2011, economic uncertainty (here and abroad) and unprecedented volatility have conspired to turn off major classes of investors who have de-risked. As a contrarian I rejoice in the fact that individual investors have redeemed $420 billion of domestic equity funds over the past five years while contributing $830 billion to (low-yielding) fixed-income products. That swing, of $1.25 trillion, since early 2007 is, by far, an all-time record change in preference of bonds over stocks. The de-risking is not confined to retail investors, as, according to this week's ISI Hedge Fund Survey, hedge funds' net long exposure is the lowest since the generational low in March 2009. Moreover, pension funds' exposure is substantially skewed toward bonds over stocks, despite the meager yield returns. A massive reallocation out of fixed income and into equities remains a growing possibility, particularly if reduced corporate profit expectations prove to be too conservative and if there is better economic traction. I lastly want to address current valuations, which I view as attractive. Risk premiums (the earnings yield less the risk-free rate of return) stand at a multi-decade high, placing stocks, in theory, even cheaper than at the March 2009 bottom. Looking out longer term in history, over the past 50 years the S&P 500 has averaged a 15.2x P/E multiple while the yield on the 10-year U.S. note averaged 6.67%. Today, the S&P 500 trades at only 12.5x (2012 earnings) while the yield on the 10-year U.S. note stands at only 2.05%.
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