Now there's no welcome look in your eyes when I reach for you
And girl you're starting to criticize little things I do
It makes me just feel like crying baby 'cause baby
Something beautiful's dying...
You've lost that loving feeling, oh that loving feeling
Bring back that loving feeling, now it's gone, gone, gone
And I can't go on, no oh oh.
-- The Righteous Brothers, "You've Lost That Lovin' Feelin'"
For many months I have projected a down year for stocks, anticipating a broad S&P 500 trading range of between 1700 and 1950 for 2014.
I am sticking to this forecast.
Some Projected Price Levels on the S&P 500
We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.
-- Warren Buffett, 1992 Berkshire Hathaway Letter to Shareholders
If I had to hazard a guess, I would say that a reasonable year-end price target for the S&P 500 would be in the 1825-1875 area. (Note: The S&P 500 closed at 1931 on Friday.)In terms of timing, I believe that we are now on the cusp of a textbook 10% correction from the 2014 highs. The first test of the S&P 500's 200-day moving average since November 2012 (namely, into the 1860 area) seems possible by the fall. I am assuming that a second and deeper test to about 1780, representing a 10% correction, will evolve a bit later in the year, which would also a near-perfect 23% Fibonacci retracement from the 2011 low. Retail investor sentiment has grown optimistic, a contrarian signal. As this chart indicates, retail investors' cash allocation has dropped to the lowest level since 1999. According to Merrill Lynch, institutional fund managers are also all in. Complacency (a self-satisfied view that fails to consider negative outcomes) remains an ongoing threat to the bull market. This is a constant concern of mine, so much that I mention it twice in today's opening missive.
Remember: this outcome is baked in the cake because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the selloffs with renewed speculation, but there's no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We don't believe that risk has been permanently removed from risky assets. The belief that it has is itself the greatest risk that investors face here.
-- Dr. John HussmanI believe that the entrenched strategy of buying the dips and the notion that short-selling is a mug's game will likely be repudiated if my ursine market assessment is correct. Risk assets are named so for a reason.
Assets Are Amiss
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."
-- Chuck Prince, former CEO of CitigroupThere was just a very good conversation on CNBC's "Squawk Box" this morning, which followed an interview with Gloom Boom & Doom Report's Marc Faber. In the discussion Joe Kernen expressed some concerns regarding certain asset prices while Scott "Judge" Wapner suggested that investors should play the hand that they are dealt and go with the upward trend. It is true that the smart ones play the hand that is dealt. But they are also students of history and recognize that even the best get duped into believing that the music will never stop. This statement applies even more accurately with the (mis)behavior of retail traders and investors. In 2007 to 2009 some of the greatest hedge-hoggers got badly tripped up by the belief that the contagion of subprime loans wouldn't upset the long economic boom and that there was so much liquidity that the global recovery of the mid-2000s would not be disrupted (see Chuck Prince quote above). Today there are arguably numerous assets that are inflated from policy and have resulted in overvaluations' cousin -- complacency (self-satisfied views that do not consider adverse outcomes). Arguably, these include but are not restricted to select social media stocks, small-caps and midcaps, the U.S. note and bond markets, sovereign debt yields (particularly in peripheral countries of Europe), and junk bonds. There is also a widespread belief that corporate profit margins are inflated, and there is confidence in the Fed's ability (and for that matter central bankers around the world) to land the economies safely. Perhaps, as Benjamin Disraeli once wrote, "What we have learned from history is that we haven't learned from history."
Escape Velocity for the U.S. Economy Remains in DoubtThe negative wealth effect of the possibility of lower stock prices could weigh further on domestic economic growth, which is already subpar in its trajectory. (Note: Though second-quarter 2014 real GDP rebound from the first quarter, inventory accumulation accounted for 1.8% of the 4.0% increase.) I started the year expecting U.S. real GDP to grow by only about 1.75%, or nearly half the rate of growth projected by the consensus. This forecast still seems intact. The significance of our economy failing to reach escape velocity cannot be overstated in its importance. Nor can the continued dependency on the Fed's generosity, even a though a full five years has passed since the Great Decession, be constructive to P/E ratios. Slower and subpar economic growth does not provide a cushion or margin of safety to our markets. Rather it exposes our markets to policy mistakes, geopolitical risks and increases the market's vulnerability to black swans (even though they might just be flappers or cygnets). Meanwhile, non-U.S. economic growth is not too sporty, and revisions lower seem likely in the weeks ahead as geopolitical risks remain on the front burner. Japan, Italy, Russia and France are likely already in recession, and the EU's real GDP growth is probably going to be under 1% this year. Importantly, we might finally see acceptance and admission that there are limitations to what the Fed and other central bankers can do further to catalyze growth in 2014-2015. This aha moment, which I previously raised as a possibility in a recent Barron's interview, could be one of the more nontrivial reagents to the market's decline.
Technical Divergences AplentyIn previous columns I have written that the rise to new highs should be carefully dissected and that potential divergences could foretell future market weakness. This has been the case with deterioration in new highs, eroding market breadth, relative underperformance in the Russell 2000, a breakdown in emerging markets and in the DAX, and other technical signs.
Financial Engineering May Finally Be Losing Its MomentumLast week also brought on some evidence -- namely, the failed deals of Sprint (S)/T-Mobile US (TMUS) and Twenty-First Century Fox (FOX)/Time Warner (TWX) -- that the spirited M&A activity (and another catalyst to the market's upside) may be slowing. (No doubt slowing global growth will stall M&A.) Aggressive share repurchase activity, which has been a clear market prop (and is often a signpost of market tops), also might be in retreat as a result of weakening economies (over there) and evidence of a top in junk bond prices and a low in junk bond yields. So, too, might inversions induced takeovers, which have buoyed market speculation, be a thing of the past if the current administration has anything to do with it. For instance, last week Walgreen (WAG) succumbed to the President's jawboning and dropped its inversion proposal. Fiscal 2013's valuation surge (when profits rose by about 7% while the S&P 500 rose in value by over 30%) has, in my view, taken away from 2014-2015 investment returns. If the support of robust financial engineering diminishes in significance, valuations are exposed.
Err on the Side of Conservatism
"Just as a cautious businessman avoids investing all his capital in one concern, so wisdom would probably admonish us also not to anticipate all our happiness from one quarter alone."
-- Sigmund FreudPrudent, cautious self-control is investment wisdom's root. My bearish market outlook places a high standard on long selections -- that is to say, you better have a damn good reason for owning a stock. My suggestion is to develop a reward vs. risk assessment for each of your longs. My favored asset class is still closed-end municipal bond funds, even though they are up by over 15% year-to-date. Discounts to net asset values remain in the high-single-digit area, and after-tax and taxable-equivalent returns remain attractive. My least favorite asset class is generally many components of the social media sector. Though I have a number of individual short positions on, only the most facile investors should be short during this anticipated market decline. Index fund plays such as shorting SPDR S&P 500 ETF (SPY) or PowerShares QQQ (QQQ) make the most sense. Short-selling requires recognition of the asymmetry of the exercise and that certain stocks (with high short interest) should mostly not be shorted because the pain of occasional short squeezes is not pleasant.
Uncertainty Remains High
"Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future."
-- Warren BuffettFinally, we must recognize that though I might have conviction of forecast, there are numerous alternative market outcomes. I don't have a concession on accurate market forecasts (nor does anyone else, for that matter). My projection is simply a distillation of my multiple concerns, and my index price targets are a function of where I believe valuations are reasonable given the economic and profit status (and risks associated to forecasts). I have a reasonably large conviction that the world and the investment backdrop have grown more dangerous. But, as I have repeatedly written, there is no certainty (especially of market outcome). The only certainty is the lack of certainty. So, I might be wrong. I am simply presenting my baseline market expectation.
This column originally appeared on Real Money Pro at 9:51 a.m. EDT on Aug. 11.
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