This commentary originally appeared on
on Oct. 10 at 9:15 a.m. EDT.
Last week I promised to ask 10 questions to both the bulls and the bears, the answers to which could help us determine the outlook for equities over the balance of the year and into 2012.
Last Monday I asked
, and today I ask 10 questions to be addressed to bearish investors.
Pace of domestic economic growth: Third-quarter 2011 GDP (in real terms) will likely expand by over 2.5%, well above 2011's first-half growth of less than 1%. This pace of growth is stronger than the consensus forecast was as recently as a month ago, as business fixed investment, personal consumption expenditures and the improving trade deficit will all be positive contributors to growth. As well, third-quarter S&P 500 corporate profit growth (aided by a still-weak jobs market, strong productivity gains and rising production) should advance to a near $100-per-share annualized rate.Sure, beyond the current results, visibility is limited, as the manufacturing orders less inventory mix produced the third negative reading in four months and the household sector labors under a decline in stock and home prices, a contraction in government jobs and stagnating wages and little progress in real incomes.Nevertheless, both the residential real estate and the U.S. automobile industries are deeply depressed, represent historically low percentages of GDP and pent-up demand will be unleashed at some point. Almost all of the other recent domestic economic releases (e.g., jobless claims, the national ISM and lower food and energy prices) signal that the U.S. will muddle through into 2012. Meanwhile corporations have already proven that they are positioned to prosper even in a relatively sluggish backdrop -- for instance, in the first half of this year, earnings exceeded expectations despite sub-1% GDP growth. Corporate balance sheets are liquid, inventories are conservatively aligned relative to sales, and profits are at record returns in third quarter 2011 (as profit margins having benefited from, among other factors, years of cutting fixed costs).
Europe and China: While Europe is a wild card, it rarely ever pays to bet on catastrophe. European leaders, though slow in response, no doubt have a full understanding of the consequences of not addressing their debt crisis. As I mentioned recently on "Fast Money," the eurozone and its banks are now experiencing a La Dolce Vita moment -- in the same way in which Marcello Mastroianni struggled between the allure of the cafe life in Rome and the responsibilities of living with his girlfriend.This was exactly what the U.S. and our financial institutions experienced three years ago -- as a country, we were forced to find our way back to recovery and our banks were forced to accept responsibility (and recapitalize) for their misdeeds.My expectation is that the eurozone will become domesticated and accept the consequences of its actions (and recapitalize). Indeed, on Sunday, Merkel and Sarkozy agreed to a eurozone bank recapitalization.As to China, the September Chinese HSBC Markit Service PMI climbed back to 53.0, a blow to those who believe in a hard landing.
Politics: As aptly depicted in Tom Friedman's New York Times op-ed yesterday and by a numerous group of disgruntled citizens, strategists and investors, it is now almost universally accepted that the division between the Republican and Democratic parties is so deep as to negate nearly any chance (or hope) of enacting pro-growth fiscal policy until the November 2012 elections. If everyone already knows this, hasn't Mr. Market discounted the Washington impasse?
Corporate profits: Sure, Ingersoll-Rand had a negative release, and others have warned, but negative preannouncements have been lighter than many expect. And some companies -- such as Nike , with its future orders in constant dollars up 13%, FedEx and others -- look pretty damn good.In light of the recently resilient economic releases, what do you think is a realistic S&P 500 profit forecast for 2012? How does that projection compare to the consensus projections and the apparent $76 a share that the S&P appears to be discounting?
Sentiment: Skepticism is now deeply rooted among investors, as sentiment continues to focus increasingly on risk rather than reward. If there has been any time in history that stock investing has been out of favor, today is that time. Retail and institutional investors have abandoned the equity market. A lost decade combined with the current near-term disenchantment with equities has placed hedge funds at their lowest net long positions since early 2009, and retail investors have continued to seek the safety of fixed-income markets despite the absence of a coupon. (Since the beginning of 2007 individual investors have had a record swing of $1.2 trillion-plus, $400 billion-plus in domestic equity fund outflows against $800 billion-plus of inflows into bonds.)There is no talking about stocks at social events anymore; there is a lot of discussion of Occupy Wall Street, though. Rolling Stone's Matt Taibbi is arguably more popular than any Wall Street strategist or CNBC commentator. Zero Hedge's traffic is soaring. One could argue, therefore, that we might be approaching another near-term extreme in negative sentiment again.Investors Intelligence bears among market letter writers rose to 45% last week, the highest since March 2009, and the NAAIM poll went to a negative exposure to equities for the first time since the first week of October 2008. The CBOE put/call ratio remained over 1.10, even during last week's rally days.So, given the crowded nature of defense being played by every class of investor, could the upside be more substantial than many believe?
Valuation: Over the last 50 years the S&P 500 has averaged 15x (while the yield on the 10-year U.S. note averaged 6.67% during that period). Today, the market's multiple is about 12x on projected 2011 profits of $95 per share (while the yield on the 10 year U.S. note is only about 2%). The risk premium (earnings yield less corporate bond rates) is at a multidecade high, placing stocks statistically (very) inexpensive on a quantitative basis. In fact (relative to interest rates), the U.S. stock market seems to be discounting 2012 S&P profits of around $60a share, a level of profits that seems incomprehensible.Given that interest rates will be low as far as the eye can see, shouldn't we give interest rate dependent valuation models more weight, and shouldn't we be attracted to a 12x multiple within the context of a 2% 10-year bond yield?Finally, stocks are even cheaper today than in late 2008 relative to sales, cash flow and earnings.
Reallocation trade: At what point do corporate pension plans, now heavily skewed towards fixed income, reallocate capital back into equities? Given their skew (favoring bond weightings over stocks) and the historically low level of bond yields (the yield on the S&P 500 exceeds the 10-year U.S. note yield), isn't a massive reallocation inevitable?
Volatility: The wild price swings have served to further erode whatever has been left of investors' confidence in the marketplace. We all recognize (and are fearful) that high-frequency-trading strategies and intra- and end-of-day re-weightings of leveraged ETFs have filled the void of inactive retail and institutional investors and have created a volatile and unpredictable market backdrop. But, historically isn't such a volatile environment exactly the sort of backdrop that has provided attractive entry points? Shouldn't investors now consider being more greedy rather than fearful, even despite the upsetting volatility?
Technicals: Early last week the market tested (and slightly undercut) the August lows. There were several positive divergences - for instance, the number of new lows was smaller than during the low of two months ago. As well, the test was followed by two 80% up days and then a 90% up day. We are now well off the lows. (Who knows? We might be in between waves 12-14 of George Lindsay's Three Peaks and a Domed House.)
S&P 500 target: About a month ago, I did a probability distribution based on four economic/market scenarios that produced an S&P 500 objective of about 1205. (See my assumptions at the end of today's opening missive) Two weeks ago, Morgan Stanley's strategy team made a similar presentation.In light of the recently better-than-expected economic signals, shouldn't both Kass, Morgan Stanley and other market participants be reassessing and lowering the recession probability (if not the modest recession scenario, then the hard recession outcome) and raising the more favorable probabilitiesBelow is a comparison of both our outputs. Given that the hard economic data remains consistent with moderate, non-recessionary growth and reasonably strong corporate profits, has the weakness in stocks shifted the reward relative to more attractive levels? Should one be underinvested given a decade-long period of market underperformance, little return available in fixed income and with retail and institutional investors having fled the U.S. stock market? Are we being too dogmatic and too pessimistic in placing probabilities on adverse economic and stock market outcomes?
My methodology, assumptions and probability distributions from a
produce an S&P 500 target of about 1205, about 5% above current levels:
Scenario No. 1 (probability 15%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts based on pro-growth fiscal policies geared toward generating job growth), still low inflation, subdued interest rates and the adoption of aggressive plans by the government to deplete the excess inventory of unsold homes. Corporate profits meet consensus for 2011, and 2012 earnings estimates are raised (modestly). Europe stabilizes, and China has a soft landing. Stocks have 25% to 30% upside over the next 12 months. S&P target is 1500.Scenario No. 2 (probability 15%): The U.S. enters a deep recession precipitated by a more pronounced negative feedback loop, a series of European bank failures and likely sovereign debt defaults in the eurozone. While 2011 corporate profits and margins disappoint somewhat (we are already well into full-year results), 2012 earnings estimates are materially slashed. China has a hard landing. Stocks have a 20% to 30% downside risk over the next 12 months. S&P target is 885.Scenario No. 3 (probability 30%): The U.S. and Europe economies experience a shallow recession. Earnings for 2011 are slightly below expectations, but 2012 corporate profits are cut back to slightly below this year's levels. Stocks have 10% to 15% downside risk over the next 12 months. S&P target is 1030.Scenario No. 4 (probability 40%): The U.S. and European economies "muddle through" in a modest expansion mode (hat tip for the term to John Mauldin). Profits for 2011 meet consensus expectations, but slippage in margins brings down 2012 corporate profit growth projections somewhat. Stocks have 10% to 20% upside over the next 12 months. S&P target is 1355.
Again, my exercise produces a mathematical solution, based on the above scenarios, of a (melded) S&P 500 price target of about 1205, about 5% above the current cash index.
Morgan Stanley Methodology
For a full explanation of Morgan Stanley's comparative methodology and assumptions, which produce an S&P 500 target of 1135 (flat with the current cash index), please go to Morgan Stanley's September 25, 2011 Investment Strategy piece.
Doug Kass writes daily for
Real Money Pro
, a premium service from TheStreet. For a free trial to
Real Money Pro
and exclusive access to Mr. Kass's daily trades and market commentary, please click here.
At the time of publication, Kass and/or his funds had no positions in the 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.