This blog post originally appeared on RealMoney Silver on Feb. 17 at 8:59 a.m. EST.
"I hate to say this, but this place is getting to me. I think I'm getting the Fear." -- Dr. Gonzo, Fear and Loathing in Las Vegas by Hunter S. Thompson
It has been several months since I have published a lengthy assessment of where we stand (and in what direction we might be going) in the economy and in the stock market. The intention of today's exercise is to lay out my baseline expectations for 2009, so please excuse the length. (For the abridged version, go to the last six words at the end of this column.)
Fear and Loathing in Las Vegas
written by Hunter S. Thompson that originally appeared as a two-part series in
magazine in 1971. Twenty-seven years later, it was adapted into a movie starring Academy Award winners Johnny Depp and Benicio Del Toro.
Though initially criticized, the book has become required reading for students of American literature.
magazine's literary critic, Mikal Gilmore, wrote that the book "peers into the best and worst mysteries of the American heart" and that the author "sought to understand how the American dream had turned a gun on itself." The critic went on to write that "the fear and loathing Hunter S. Thompson was writing about -- a dread of both interior demons and the psychic landscape of the nation around him -- wasn't merely his own; he was also giving voice to the mind-set of a generation that had held high ideals and was now crashing hard against the walls of American reality."
It all sounds familiar, doesn't it?
The "wave speech" at the end of Thompson's eighth chapter is considered by many to have most completely captured the hippie zeitgeist of the 1960s. It is a metaphor for our economic state as well.
There was madness in any direction, at any hour. If not across the Bay, then up the Golden Gate or down 101 to Los Altos or La Honda.... You could strike sparks anywhere. There was a fantastic universal sense that whatever we were doing was right, that we were winning.... And that, I think, was the handle -- that sense of inevitable victory over the forces of Old and Evil. Not in any mean or military sense; we didn't need that. Our energy would simply prevail. There was no point in fighting -- on our side or theirs. We had all the momentum; we were riding the crest of a high and beautiful wave.... So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark -- that place where the wave finally broke and rolled back.-- Hunter S. Thompson, Fear and Loathing in Las Vegas, "The Wave Speech"
became a benchmark in American literature about U.S. society in the 1960s and the early 1970s, the melodrama of the last five years is becoming a seminal economic and investment experience.
The parallel between the drug addictions in Hunter S. Thompson's book and the credit addictions in the New Millennium hold similarities, and the withdrawal from the most recent dependency on debt has had unrivaled implications. The unwind will continue to be painful for some time to come.
"Sometimes I lie awake at night, and I ask, 'Where have I gone wrong?' Then a voice says to me, 'This is going to take more than one night.'" -- Charles M. Schulz
It took a while for our country to turn around from the 1960s. There are still those who have not left the decade of peace and love (many of whom seem to still reside in Ithaca, N.Y.!). Similarly, it will likely take time for our country to turn around from the abuse of credit and the consumption binge experienced in the 2000-2006 interim interval.
A moment last Monday, just after noon, in Manhattan.... I'm in the 90s on Fifth heading south, enjoying the broad avenue, the trees, the wide cobblestone walkway that rings Central Park. Suddenly I realize: Something's odd here. Something's strange. It's quiet. I can hear each car go by. The traffic's not an indistinct roar. The sidewalks aren't full, as they normally are. It's like a holiday, but it's not, it's the middle of a business day in February. I thought back to two weeks before when a friend and I zoomed down Park Avenue at evening rush hour in what should have been bumper-to-bumper traffic.This is New York five months into hard times.One senses it, for the first time: a shift in energy. Something new has taken hold, a new air of peace, perhaps, or tentativeness. The old hustle and bustle, the wild and daily assertion of dynamism, is calmed....Any great nation would worry at closed-up shops and a professional governing class that doesn't have a clue what to do. But a great nation that fears, deep down, that it may be becoming more Suley than Sully -- that nation will enter a true depression.-- Peggy Noonan, The Wall Street Journal op-ed, " Is 'Octomom' America's Future?"
Nowadays, investors lead lives of noisy desperation.
The fear and loathing is palpable:
- It is palpable every time investors read their monthly brokerage, hedge fund and 401(k) statements.
- It is palpable in the loss of wealth in our educational institutions, corporate pension plans and endowments.
- It is palpable in the lost liquidity and lost confidence in the gating of some hedge fund investments.
- It is palpable in the obliteration of value in private equity.
Fear and loathing also abounds from the
of our all-too-visible political process, which has served to further reinforce a negative feedback loop.
The headwinds working against an economic resolution this year seem cast in stone. Those few who still
in a second-half recovery, similar to the characters Raoul Duke and Dr. Gonzo in
Fear and Loathing in Las Vegas
, are either taking too many drugs or are oblivious to the clogged transmission of credit, the steady drop in business and investor confidence and the general waning of business activity.
And I don't know about you, but I've got a sick feeling in the pit of my stomach -- a feeling that America just isn't rising to the greatest economic challenge in 70 years. The best may not lack all conviction, but they seem alarmingly willing to settle for half-measures. And the worst are, as ever, full of passionate intensity, oblivious to the grotesque failure of their doctrine in practice.-- Paul Krugman, The New York Times op-ed, " Failure to Rise"
There are significant positive developments amid the tumult that are currently being ignored.
Investor return and economic expectations have been ratcheted down as business activity is reset lower. As illustrated above, even Peggy Noonan's normally optimistic prose in
has disappeared; she is sounding almost Krugman-esque in the face of the current economic malaise. Today, there is almost unanimity that neither an aggressive monetary policy nor a massive stimulus program nor an unprecedented and large bank rescue plan will have any possibility of success. Another positive. And, with the exception of the few remaining permabulls, most now appreciate that the consumer is cooked and that the great unwind of credit will be a headwind measuring in years not months.
Some more optimistic signs can be seen in sentiment such as the growing popularity of Cassandras (especially of a Roubini kind) as well as the better price action of certain segments of the market. (Markets always lead fundamentals.) In markets, all is not financial. Just look at the charts of
Freeport-McMoRan Copper & Gold
as examples of conspicuous outperformers and proof positive that
in this desultory backdrop. The emergence of this sort of performance is a positive market tell and is a growing contrast to the uniform and correlated drop in almost every asset class during the second half of 2008.
In and of itself, an extremely negative sentiment cannot be expected to be an overriding tailwind in a backdrop of uncertainty. Despite the poor market landscape, however, there are some early signs of stability/revival, even before the stimulus is put in place. They are, admittedly, tentative signs but positive signs nonetheless.
Here is a partial check list of signs that I and others are looking for (and their status in italics) as indications for a more favorable stock market:
- Bank balance sheets must be recapitalized.We await a bank rescue package in the week ahead.
- Bank lending must be restored.Bank lending standards remain tight. For now, we are in a liquidity trap.
- Financial stocks' performance must improve.We are not yet there. Financials' performance is still drek.
- Commodity prices must rise as confirmation of worldwide economic growth.There has been some recent evidence of higher commodities, but it's still inconclusive.
- Credit spreads and credit availability must improve.While credit spreads are improving, the yield curve is rising and interest rates have rebounded, the transmission of credit remains poor. Time will tell whether monetary and fiscal policies will serve to unclog credit.
- We need evidence of a bottom in the economy, housing markets and housing prices.The economy's downturn continues apace. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize despite an improvement in affordability indices.
- We also need evidence of more favorable reactions to disappointing earnings and weak guidance.We are not yet there, but this will tell us a lot about the state of the stock market's discounting process.
- Emerging markets must improve.China's economy (PMI and retail sales) and the performance of its year-to-date stock market have turned decidedly more constructive.
- Market volatility must decline.The world's stock markets remain more volatile than a Mexican jumping bean.
- Hedge fund and mutual fund redemptions must ease.While I am comfortable in writing that most of the forced redemptions have likely passed, we will find out more over the next few months. Regardless, the disintermediation and disarray of hedge funds and fund of funds have a ways to go.
- A marginal buyer must emerge.Pension funds seem to be the likely marginal buyer as they reallocate out of fixed income into equities, but we have not yet seen the emergence of this trend.
While sentiment and valuation are not the sine qua non in determining share prices, it should be underscored that the current bear market is the second-worst in history, both in terms of price decline and the erosion in P/E multiples. This means that embedded expectations are low. While sentiment, as measured by hedge fund and mutual fund redemptions, remains acutely negative, individual, sovereign and institutional liquidity remains abundant and is growing swiftly.
On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:
The risk premium, the market's earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
Valuations are low vis-à-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.
The most common cause of low prices is pessimism. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling.-- Warren Buffett
Today's growing investor disaffection and apathy with regard to equities has, at it's root, Hunter S. Thompson's fear and loathing. Both have given voice to the mind-set of a generation that had held high ideals and, as it relates to stocks in 2009, is now crashing hard against the walls of American reality in credit and finance.
If it all sounds familiar, it is, as both the 1960s and the 2000s were the decades of dopes.
After the speculative boom of the 1960s, the U.S. stock market fell into the early 1970s, but the extension of the popularity of the "Nifty Fifty" kept the market in gear for a few more years. After the Nifty Fifty bust in 1973-1974, the markets resumed a modest ascent in 1975, which petered out two years later. By 1982, 12 years after the close of the 1960s, the
began, despite loud chants that "the sky was falling" by the increasingly populated community of Cassandras.
"My pessimism goes to the point of suspecting the sincerity of the pessimists." -- Edmond Rostand
Most investors entered 2008 with a far too constructive market and economic view. I did not as I consistently chronicled my economic, housing, credit and stock market concerns throughout 2007 against the roars of the bullish chorus on The Edge (my exclusive trading diary on
The Wall Street Journal
(among other venues).
It seems that the benefits of a greybeard's historical perspective had its rewards. Most of my concerns have been realized. To be honest, most of my concerns have been eclipsed in recent months.
As we move into the midway point of the second month of 2009, market participants generally now have the opposite point of view of 14 months ago. I respect the fear and loathing, but I do not share the prevailing pessimistic view that John Mauldin substantiates in his brilliant and peripatetic "
" this week, as he argues that world trade is falling off the cliff, the magnitude of the world's bank write-offs are daunting and unknown, leading economic indicators are deteriorating, job losses are intensifying, S&P earnings are being adjusted downward to unfathomable levels, Secretary Geithner's bank rescue package is vague and that the stimulus program might only be a Band-Aid over a broadening set of problems.
It's, well, downright maudlin!
Today, the doomsayers are far more visible compared to after the dissolution of the Nifty Fifty advance in the 1970s, but my sense is that we don't have to wait anywhere near seven years (2016) for a resumption of a new bull market as policy is going to be aggressive and immediate.
Arguably, John Mauldin's (and others') issues are now being incorporated into market expectations.
My economic view remains materially unchanged. We are likely in
, somewhere in between a garden variety recession and The Great Depression of the 1930s. We will, in the months ahead, continue to find out the many whom have been swimming naked as the tide goes out. And to continue with the Oracle of Omaha's references, it might be too early to be greedy when others are fearful, but I suspect that we are not far off from there.
The average recession in modern financial history has lasted 10.5 months. The longest recession was between 1929 and 1933 -- real GDP dropped by over 25%! -- and lasted 43 months; the shortest (1980) lasted only six months. I expect The Great Decession, which began in November/December 2007, to end in early 2010, or about 12 months from now. If accurate, the current recession will be the second worst on record, having lasted about 27 months.
It's so bad out there that some are questioning whether the world's economies will ever recover from the current mess. In doing so, they seem to be ignoring not only an emerging valuation opportunity but a number of events that should conspire to bring us out of the abyss, including (but not solely) the magnitude of the monetary and fiscal stimulation, the consumer tax cut and corporations' margin benefit from lower commodities (particularly of an energy kind), improving investor liquidity, the lowered cost of credit and a sentiment extreme of negativity.
At the risk of going Gonzo or garnering allegations that I could now be suffering from a hallucinogenic flashback from the 1960s, starting to average into the U.S. stock market could begin to make sense sooner than later.
When I objectively weigh all the body of evidence (the positives and the negatives above), I conclude that we are likely at the lower end of a broad trading range for the S&P 500. Fourth-quarter 2008 lows should hold.
We almost certainly remain in an exquisite trading market but an unimpressive investing (buy-and-hold) market for numerous reasons, including the great unwind of debt, the hit to household wealth and psychology after the deep drops in home and equity prices, the unique nature of this cycle's synchronized world economic falloff and the uncertainty of policy. Thus, a sustained market advance remains a low probability.
While much economic and corporate ugliness can and will likely occur in the year ahead, if year-end 2009 does mark the beginning of the end of The Great Decession, as I have surmised, stocks over the next few months will likely begin to discount stabilization well in advance, especially given the reasonable levels of valuation addressed previously.
To conclude, the lowering of the bar could be closer than many think, but the path to reach it remains icy, so investors should still tread carefully.
Despite the fear and loathing on the part of investors, I am beginning to find value and, for the first time in several years, I am in a (slightly) net long position.
Gun to my head, my baseline expectation is that the S&P could end up with a mid- to high-single-digit return for the full year, or about 15% above current levels.
Many stocks will rise more dramatically.
Color me a bit more bullish.
Doug Kass writes daily for
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At the time of publication, Kass and/or his funds were long Transocean, Freeport-McMoRan Copper & Gold and MedcoHealth Solutions, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Long/Short LP.