"Neutrality is the best that you can have at this point. I think it is the right place to be -- on the sidelines. I hate to call it panic, but it has some distance to the downside. As Dougie Kass says, "Risk happens fast." -- Dennis Gartman, CNBC's " Fast Money" (Feb. 3, 2014)
Over the past few months, I have
for my downbeat market view.
To summarize my concerns:
- Corporate profit margins (70% above historical averages) are stretched to 70-year highs, so earnings are exposed. The 2014 consensus forecast of $120 a share for the S&P 500 is likely too high. (I live much lower.)
- Second-half 2013 strength in domestic economic growth had been boosted by nonrecurring inventory accumulation. Some more recent domestic signs (e.g., automobile sales, industrial production, retail spending and housing data) suggested a deceleration in U.S. growth. Signposts in China and other areas of the world also dictate caution of economic forecast.
- The baton exchange from Helicopter Ben to Whirlybird Janet could be unkind to the markets. On average, a change in the Fed chair has resulted in about a 7% drop in the major stock indices -- almost the exact drop experienced thus far in 2014.
- Quantitative easing may not be a continued tailwind for stocks. As Peter Boockvar wrote, "QE doesn't create a safer world, it is just a temporary high, and the danger always comes on the flip side as previously seen.... QE puts beer goggles on investors by creating a line of sight where everything looks good, but the Fed's current plan is to end it by year-end." As we have quickly found out, price discovery (coincident with a tapering) can be a bear.
- Sentiment measures were elevated to historically bullish levels. This is seen not only in the disparity between bulls and bears in the popular surveys but also manifested in the third-highest margin debt to GDP in history (a level of borrowing that had been rationalized away by the bullish cabal).
- Valuations (i.e., P/E ratios) rose by nearly 25% in 2013 vs. only 2% annually since the late-1980s.
- The Shiller P/E ratio ended 2013 at or near historic highs (excluding the bubble of the late-1990s).
- According to JPMorgan, at year-end 2013, the S&P 500 was more expensive on a forward P/E basis than it was at its previous peak in October 2007.
- Interest rates might pose more of a threat than is generally viewed. The rose-colored glasses being worn by investors might be cleared in the year ahead, as the withdrawal from QE and low rates might be harsher in influence.
- The perilous state of the economies in many of the emerging markets and undeveloped world was ignored by investors. The adoption of a less liberal monetary policy in the U.S. might expose those who are swimming naked.
- A year ago, market enthusiasm was muted. As we entered this year, there were no cautionary forecasts for the S&P for the next 12 months by any of the leading market strategists.
The Return of Natural Price Discovery
In November 2010, Ben Bernanke penned a piece for The Washington Post defending the initiation of QE2. In it, he cited one of the early signs of success, that "stock prices rose ... and higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."Back in June 2013 on CNBC We also know that asset prices go up and down.Blame it on China, Turkey, Argentina, and/or mixed U.S. data and the weather, but we're potentially seeing the same stock price TV show that was played after QE1 and QE2 ended, which now, in turn, is begging the question from some of whether the Fed should end the taper and thus put us back on this endless and unwinnable vicious cycle of QE. At the cost of further downside in equity prices, potentially much more so (I reaffirm my beginning of the year 1550-1600 price target range as the 2013 QE fluff comes out of the market), and whatever broader problems this will bring, I hope the Fed keeps on cutting QE, as Atlas of the stock market they should not be, and an economy dependent on savings and investment, I hope, will eventually win out. I'll say again, there will never be a good time to end QE/ZIRP, and we will not be able to avoid the short-term pain of it, but it must take place for the sake of the long-term health of the U.S. and global economies.-- Peter Boockvar, The Lindsey Group
As I think back to 2013 and realize how stupid I and the small number of other bears were at times during the year, I can't help but think that last year was simply a QE-driven aberration and that the weakening market thus far in 2014 is the normalization of markets as a more natural price discovery has taken center stage.
As we entered this year:
- Japan was supposed to be the most rewarding region in which to invest -- the Nikkei was down 4% yesterday and is now -14% year to date;
- stocks were forecast to dramatically outperform bonds (fixed income has materially outperformed equities);
- the rate of global economic growth was set to accelerate -- it is decelerating; and
- interest rates would be on the ascent -- the yield on the 10-year U.S. note has declined by 40 basis points so far this year).
My out-of-consensus 2014 market and asset class expectations are unaltered and appear to be on the path of being more accurate than most:
- a 5% to 15% drop in the S&P 500 in 2014 -- stocks were down 4% in January;
- bonds outperform stocks, with closed-end municipal bond funds the best asset class of the year (up 9% in January);
- the yield on the 10-year U.S. note ranges 2.5% to 3% -- yields have dropped by 40 basis points in January;
- global and domestic economies grow substantially less than consensus;
- 2014 S&P profits meet $112 a share, well below expectations;
- P/E ratios decline after expanding by nearly 25% in 2013; and
- the emerging markets are upended by continuing crises -- the developed world suffers collateral damage.
How Now, Dow Jones?
"Price is what you pay, value is what you get." -- Warren Buffett
All is not lost.
I have learned over a few decades that holding onto dogma (bullish or bearish) is not a way to deliver superior investment returns.
Rather, one should listen to The Oracle of Omaha's words above. Indeed, one should listen to all of The Oracle's words!
Warren Buffett's lesson is that while optimism is the enemy of the rational buyer, there is always a price that an investor and/or trader can pay to acquire value.
As subscribers know, I always think in terms of reward vs. risk on the stock market and for specific equities.
I create a
based on a scenario analysis of economic, profit and interest rate assumptions. At present, my calculation leads me to believe that fair market value resides around 1645 for the S&P 500, but my process is a guideline and not meant to be hardened or precise in forecast.
There is simply no special sauce and no calculation of fair market value that is right - again, the formula is a signpost and an exercise in determining where stocks should be valued given a set of dependent variables.
During the last week, I have written that I expect the S&P 500 will be in a range of between 1625 on the downside and 1925 on the upside for 2014.
At Monday's close, the S&P 500 stood at about 1750.
In other words, the reward (+11%) vs. risk (-7%) in the U.S. stock market, for the first time in months, has now turned more favorable with Monday's schmeissing. (Note: The U.S. stock market, using my fair market valuation is still not yet statistically attractive, as reward and risk seems to be more or less in balance.)
Risk and contagion happen very fast.
Thus far, 2014 has served as a serious challenge to many of the consensus expectations.
The investing and economic backdrops might have likely experienced a trend change -- and not for the better. Despite the certainty of view in many quarters, we won't be able to determine whether the market weakness over the last five weeks is a trend change, as the
certainty is the lack of market certainty.
At this point of the year, we have witnessed an early-inning rout of consensus. As the lopsided market rout deepened in the last few days, a late-game recovery seems to be growing more unlikely.
That said, stocks now appear fairly priced, with reward and risk essentially in equilibrium.
Reflecting this view, I am in a market-neutral position.
My investing mantra remains of the view that opportunistic trading will continue to trump investing.
A further drop in equities towards fair market value would change my posture and lead me toward the search for investment opportunities.
This column originally appeared on
Real Money Pro
at 8:43 a.m. EST on Feb. 4.
At the time of publication, Kass and/or his funds had no positions in any stocks mentioned, although holdings can change at any time.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.