This commentary originally appeared on Real Money Pro on Sept. 12 at 7:53 a.m. EDT.
I view share prices of many companies as having become generally more attractive over the last two months, but, at this point in time, there are four factors that keep me from being more heavily committed to equities:
the stock market's continued volatility and instability;
the growing sovereign debt contagion in Europe (and failure of their leaders/central bankers to respond intelligently);
continuing political partisanship (and failure of our leaders to properly confront our fiscal imbalances and to promote pro-growth policy); and
an inability to gauge whether the erosion in the August sentiment measures (impacted by U.S. stock market and domestic/overseas economic uncertainties) will translate into weakness in hard domestic economic data.
What makes matters current conditions even more difficult to gauge is that resolution of the aforementioned fiscal imbalances (in the U.S. and overseas) is dependent on the effective imposition of bold and creative fiscal and monetary policy. Recent and past historical experiences suggest that it is rarely a good bet to hold on to, be dependent on and put heavy weight upon the hope that our world's political leaders and central bankers will rise to the occasion. We are walking on what is looking more and more like a tightrope in which recovery is being weighed down by the aftermath of the last cycle of excessive debt creation and the lack of financial responsibility (and growing imbalances) across the private and public sectors.
In this setting, there are more numerous economic (and stock market) outcomes than are usual. As I have expressed recently. I see the following four potential outcomes:
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.
target is 1500.
Scenario No. 2
(probability 15%): The U.S. enters a deep recession precipitated by a more pronounced
, 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
). 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.
A Muddle-Through Economy Remains Base Case
While I appreciate the uniqueness of the current balance sheet recession and the growth-deflating impact of deleveraging, I am also mindful that the typical conditions that precede a recession are not in place:
- large private payroll drops in excess of 175,000 a month (adjusting for nonrecurring issues, payrolls are still averaging about 95,000 growth over last four months);
- an inverted yield curve (it is positively sloped);
- acceleration in inflation (inflation is contained and so are expectations);
- an increase in real interest rates (anything but!);
- bloated corporate inventories (low inventories to sales in place now);
- retreating retail sales (they are expanding);
- negative year-over-year leading economic indicators (advancing now);
- a drop in factory orders (also rising) and;
- outsized durable spending relative to GDP (housing and autos remain at or near cyclical lows).
As it relates to job growth, initial jobless claims, the government's job openings/labor turnover report (JOLTS), corporate profit growth, capital spending and ISM (manufacturing and nonmanufacturing) data all point to improving and better payroll growth than we saw in the recently released disappointing August data. But what is happening is that the negative feedback loop has taken a turn for the worse (as the decline in risk assets has begun to weigh on the real economy). Unfortunately, for now, no one knows the precise impact that the drop in the value of risk assets and the marked erosion in sentiment measures will have on business expansion and hiring plans nor on consumer spending intentions.
My baseline economic expectation is that the U.S. economy muddles through with modest (about 1% to 2%) growth over the next two years, a strong enough growth plan to produce healthy corporate profits but not to put a dent in the unemployment rate. I especially like and I am in agreement with Oaktree Capital Management's Howard Marks' recent characterization of the U.S. economy as "an airplane rising weakly, perhaps overloaded or with an engine sputtering and thus having difficulty getting above stall speed. Its sluggishness constitutes a drag and introduces risk, but predicting deceleration is going too far." Unfortunately, the economic and earnings risks still remain to the downside, but we should emphasize that expectations are now low, too, as according to our calculations market participants are assuming about a 30% to 40% probability of recession.
A Growing Bull Market in Negativity
As a reflection of the loss in investor confidence, hedge fund net exposure is now at the lowest level since summer 2009. Individual investors, too, have dramatically abandoned the U.S. stock market. In June, nearly $21 billion was redeemed from domestic equity funds by retail investors. In July, almost $29 billion was withdrawn. In August, it has been estimated that more than $35 billion poured out. The $85 billion of outflows from June to August will likely approach the previous three-month record of $88 billion, which came out of domestic equity funds between September and November of 2008. Thus far in 2011, individual investors have sold about $75 billion of domestic equity funds, only $10 billion less than last year's total outflows. Astonishingly, since the beginning of 2007, domestic equity mutual funds have had net outflows of more than $400 billion -- in the same period, $835 billion of fixed-income funds have been purchased. That spread between stock outflows and bond inflows ($1.235 trillion) is unprecedented in the annals of financial history.
Value Has Emerged but Only In Theory
Meanwhile valuations are growing more attractive in the face of adequate and sustainable (but not spectacular) corporate profit growth that we forecast for 2011-2012 and within the context of unusually strong corporate balance sheets, low interest rates, contained inflation and a market-friendly Fed.
Today over 55% of the companies listed in the S&P 500 yield more than the U.S. 10-year note. The earnings yield (the inverse of the P/E multiple) less the yield on corporate bonds is as wide as its been in decades, and the possibility of a meaningful reallocation out of record low-yielding fixed income into more attractively priced stocks could produce a surprising upturn in the U.S. stock market once there is better economic clarity both domestically and overseas.
Most importantly, many stocks that I have thoroughly researched are now relatively inexpensive -- that is, if we skirt a domestic recession and if the European sovereign debt problems are addressed by Europe's Central Bankers. Moreover, I am convinced that mounting overseas issues could potentially result in the U.S. economy being among the best houses in a bad neighborhood and our stock market may be seen as a relatively safe haven in the period ahead.
In summary, investors should be prepared to expand net long exposures when:
we gain better macroeconomic clarity (both domestically and overseas);
the world's stock markets begin to stabilize;
we see evidence that the sovereign debt crisis in the Euro Zone has subsided (because of more proactive ECB policy); and
our political leaders (hopefully) grow less divided and begin to promote and sanction pro-growth fiscal policies.
The good news is that while the world remains imperfect and economic risks abound, many of our long held structural concerns (that will weigh down worldwide economic profit growth) may finally be in the process of being discounted.
The bad news is that, over the short term, investors have become increasingly dependent upon the weight of successful policy implementation (here and abroad), and the history over other periods of major economic challenges (as well as in the immediate past) suggests that we may continue to be disappointed by the world's political and monetary leaders.
Looking out beyond the near term, I fully expect (as I have for some time) that the economic outlook ahead will not be as dynamic and prosperous as in past years, but buying stocks on the cheap is an antidote to a less ebullient growth environment and provides a margin of safety in more precarious and in lower growth settings.
Until we see some resolution of these issues and/or share prices move lower, investors should move forward with caution as a wide range of economic, corporate profit and stock market outcomes lie ahead.
For now, continue to err on the side of conservatism by being more concerned with return of capital than return on capital.
Doug Kass writes daily for
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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.