This blog post originally appeared on RealMoney Silver on July 6 at 8:30 a.m. EDT.In contrast to the complacency that embodied the rally in the S&P 500 when it vaulted over 1,230 in April, fear has now been introduced into the market.
The Ranks of Cassandras Grow
For a rough parallel, he said, go all the way back to England and the collapse of the South Sea Bubble in 1720, a crash that deterred people "from buying stocks for 100 years," he said. This time, he said, "If I'm right, it will be such a shock that people will be telling their grandkids many years from now, 'Don't touch stocks.' -- New York Times interview with Bob PrechterOn cue, the New York Times Jeff Sommer prominently interviewed Bob Prechter in Sunday's Business section. The Elliott Wave devotee is forecasting a DJIA "well below 1,000 in the next five or six years." Prechter's comments are a classic example of Roubini-like hyperbole. As I have often written, both perma-bulls and perma-bears are attention-getters, not money-makers. Avoid their views like plagues. I do. Those views might make for juicy headlines, but they are not typically substantiated by rigorous in analysis. Importantly, their views rarely prove accurate or value-added. It is for these reasons and others that the reputations of Cassandras are not usually long-lived.
The World Grows More RealisticTwo months ago, things were not as good as they appeared, and now things are probably not as bad as they seem. Two months ago, many strategists/hedge-hoggers were targeting a 1,300 level for the S&P 500, and now, in the face of what should have been an expected slowdown in the rate of growth, some of the same optimists have abruptly reversed their constructive views (e.g., Barton Biggs. When the market was in an uptrend that seemed never-ending, I argued that economic expectations were too optimistic and that a zero-interest-rate policy would catalyze growth but would not likely lead to a self-sustaining economic cycle. I opined that it was different this time -- jobs growth would be lackluster (as we had entered the era of the temporary worker), housing's recovery would be tepid (despite historically low mortgage rates) -- and that these factors (among others) had produced a limited margin of safety for stock prices. A period of lumpy and inconsistent economic growth lied ahead, I opined -- one that would be difficult for investment and corporate managers to navigate. As stocks corrected, slowly at first and then with greater tenacity, I have recently expressed the view that the equity market was beginning to take a path of fear rather than traversing the path of fundamentals. Many of my concerns have been now adopted in the consensus, and, in reaction, share prices are now overshooting lows that I had expected to be supported by conservative but elevated and reasonable profit estimates.
Though the market's price momentum (the voting machine) is horrible, valuations (the weighing machine) are compelling, representing the classic conflict between the trader and the investor. It is important to recognize that, notwithstanding the yearlong rally from March 2009, stocks have been stagnant for years. (The S&P 500 is now back to levels seen in late 2001.) So, as an asset class, stocks were never stretched to the degree of other asset classes -- commodities, private equity, residential and nonresidential real estate were all lifted to multiple-sigma events. I do try to remain realistic and recognize many of the reasons for the lack of progress in equities in nearly a decade. As I wrote in " The Decline and Fall of P/E Multiples," some discount from historic ratios seems appropriate given the reality of the current and prospective cycle. Most notably, taxes are rising, fiscal imbalances are large and unprecedented, there is an absence of drivers to replace the prior cycle's strength in residential and nonresidential construction, the tail of the last credit cycle remains long during the current deleveraging environment, and we have remarkably inept and partisan politics. These factors, now increasingly accepted by many, will serve to cap the upside of equities but not preclude a healthy advance, as, with an 8.8% earnings yield against a 2.95% return on the 10-year U.S. note, the corporate profits/interest rate differential is among the widest in decades. (The same favorable comparison applies to stocks vis-a-vis investment-grade bonds.) In other words, the U.S. stock market's P/E multiple of 11.5 times compares quite favorably with a U.S. bond market's P/E multiple of over 33 times. Interest rate indicators are mixed in terms of their growth message. Though the absolute level of treasury and investment-grade yields indicate less than 1% real growth, the Fed's own model indicates less than a 5% chance of recession, and the shape of the yield curve points to continued growth. My baseline expectation is that, despite the hyperbolic dire market warnings and the admittedly poor price action in the markets around the world, the domestic economy is simply decelerating from a V-shaped recovery toward moderate expansion.
Though a further drop in stocks will take more of a bite out of consumer confidence and spending, I continue to expect corporate profits to remain high, and, despite the current economic soft patch, I see little to alter my expectations, as companies successfully navigate an environment of relatively slow growth with productivity gains and a tight lid on costs. I still see S&P earnings approximating $90 a share in 2011, slightly better than 2.0% economic growth (in the second half of 2010 and for all of 2011) and steady (albeit subdued) jobs creation. U.S. stocks now sell at only 11.5 times vs. a multi-decade average of 15.3 times and at over 17 times during comparable periods of quiescent inflation and interest rates. By contrast, at 1,020, the S&P appears to be discounting slightly less than $70 a share in 2011 S&P profits, approximately 0.5% economic growth and some job losses. Stated simply, expectations for the economy and markets are now reduced and are now more reasonable.