This blog post originally appeared on RealMoney Silver on April 11 at 9:30 a.m. EDT.
Kilgore (Robert Duvall): Smell that? You smell that?Over the last 24 months, the cyclical tailwinds of fiscal and monetary stimulation have served to raise the animal spirits and investors' willingness to buy longer-dated assets such as equities and commodities (soft and hard). The Bernanke Put (and a zero-interest-rate policy) replaced the Greenspan Put (but with a far more generous exercise price!), and market valuations have risen dramatically in the latest two-year period. Since the market's low, as measured against trailing-12-month sales, equity capitalizations have increased as a percent of sales from 75% to 140%. And by my own calculation, stocks have risen from 13x-14x to 16x-16.5x normalized earnings. Nevertheless, bulls, such as Legg Mason's ( LM) Bill Miller, somewhat disingenuously argue that the doubling in stock prices is reasonable within the context of a doubling in corporate profits. But those same bulls conveniently (and selectively) dismiss the notion of normalized (not margin-inflated) earnings, while they liberally employed normalized earnings as justification for owning stocks when profits disappeared in the late-2008/early-2009 interim interval. ( Bank of America's ( BAC) Bianco and Yale's Shiller engaged in an interesting discussion of valuations in Saturday's Wall Street Journal.) During the same time frame, fear has made a new low, and complacency has made a new high, as reflected in a teenage-size VIX and a marked imbalance between bulls and bears in most investor sentiment surveys. To put it mildly, and to state the obvious, market skepticism has not paid off. Indeed, the pessimists have been written off (and even ridiculed), similar to the zeal in which the optimists were written off 24 months ago. The stimulation so necessary in keeping the world's financial and economic system from falling off the cliff has come at a cost (and with potential risks), as reflected in rising commodities and precious metals prices. The impact of policy has relieved us from the depths of the Great Decession -- I call it this because the 2008-2009 contraction was somewhere between the Great Depression of the 1930s and a garden-variety Recession -- but has arguably burdened the U.S. with large due bills, positioning the domestic economy with a potentially weak foundation for growth.
Lance (Sam Bottoms): What?
Kilgore: Napalm, son. Nothing else in the world smells like that.
Kilgore: I love the smell of napalm in the morning. You know, one time we had a hill bombed, for 12 hours. When it was all over, I walked up. We didn't find one of 'em, not one stinkin' dink body. The smell, you know that gasoline smell, the whole hill. Smelled like victory. Someday this war's gonna end. -- Apocalypse Now
Consider these possible headwinds to a smooth and self-sustaining trajectory of growth:
- Oil Vey. Higher energy costs remain the biggest risk to profit and worldwide economic growth -- it is the greatest and most pernicious tax of all. As I have documented in The Edge (my exclusive RealMoney Silver trading diary), the rapid rate of change in the price of crude oil has historically presaged weakness in U.S. stock prices.
Brent Crude -- 26-Week ROC
S&P 500 -- 26-Week ROC
- Higher Input Prices. Besides energy prices, a broadening rise in input prices also threaten corporate profit margins. While Bernanke is unconcerned with rising inflationary pressures and the CRB Index, as the Economic Cycle Research Institute notes, the Fed runs the risk, once again, of being behind the inflation curve and, in the fullness of time, being faced with the need to introduce policies that could snuff out growth with errant policy. Hershey (HSY), Procter & Gamble (PG), Colgate-Palmolive (CL), McDonald's (MCD), Wal-Mart (WMT) and Kimberly-Clark (KMB) have all announced sharp price increases (of 5% to 10%) in the cost of their staple products, running from chocolate kisses to diapers!
- A Debased U.S. Currency. The cost of 2008-2011 policy is a mushrooming and outsized deficit. Since the generational low in March 2009, the U.S. dollar has dropped by over 23% against the euro, as market participants have dismissed the notion that the hard decisions to reduce the deficit will be implemented. As Nicholas Kristof wrote in The New York Times yesterday, "This isn't the government we are watching, it's junior high school.... We're governed by self-absorbed, reckless children.... The budget war reflects inanity, incompetence and cowardice that are sadly inexplicable." At the opposite side of our plunging currency is the message of ever-higher gold prices. (Warning: Dismissing the meaning of $1,500-per-ounce gold might be hazardous to your financial and investment well-being.)
- The Rich Get Richer, the Poor Go to Prison but Everyone Else Is Victimized by Screwflation. Most importantly, policies have placed continued pressures on the middle class, with the cost of necessities ever-rising and wage growth nearly nonexistent. The savers' class has suffered painfully from zero-interest-rate policy and quantitative-easing, policies that have contributed to the inflation in financial assets (and to an across the board hike, or consumer tax, in commodity prices) but have failed to trickle down (until recently) to better jobs growth, to an improving housing picture or to an opportunity for reduced consumer borrowing costs and credit availability. Meanwhile, the schism between the haves (large corporations) and the have-nots (the average Joe) has widened, as best reflected in near-record S&P 500 profits and a 57-year high in margins. Corporations have feasted (and rolled over their debt) in the currently artificial interest rate setting, but the consumer and small businessman has not fared as well. Particularly disappointing has been overall jobs growth (as reflected in the labor participation rate) and the absence of wage growth (as the average workweek and average hourly earnings continue to disappoint). It is my view that ultimately corporations' margins will be victimized by the screwflation of the middle class, as rising costs may produce demand-destruction and an inability for companies to pass on their higher business costs.
- Structural Unemployment Is Ever-Present. Globalization, technological advances and the use of temporary workers becoming a permanent condition of the workplace are all conspiring to keep unemployment elevated and wage growth restrained. The lower the skill grade and income, the worse the outlook for job opportunities and real income growth. (This is not a statement of class warfare; it's a statement of fact.)
- Home Prices Remain Pressured. Meanwhile, the consumer's most important asset, his home, continues to deflate in value, despite the massively stimulus policies, a multi-decade high in affordability, improving economics of home ownership vs. renting and burgeoning pent-up demand (reflecting normal population and household formation growth). Consumer confidence has continued to suffer from the unprecedented home price drop, which has been exacerbated by the aforementioned (and decade-plus) stagnation in real incomes. The toxic cocktail of weak home prices, limited wage growth and nagging upside commodity price pressures (particularly from the price of gasoline), will likely pressure retail spending for the remainder of 2011.
First-quarter 2011 business activity likely ended weaker than expected, with first-quarter 2011GDP demonstrating about a +2.5% rate of growth (far less than the near-4% consensus expectation of a few months ago). As economist and friend Vince Malanga mentioned to me over the weekend, the forward economic outlook is not inspiring and is showing signs of decelerating growth: "March ISM manufacturing index showed notable declines in the growth rates for orders, exports and order backlogs.... And core capital goods orders were surprisingly weak in both January and February." If businesses begin to treat the geopolitical crises and elevated oil prices as more permanent conditions, order cancellations and corporate-spending deferrals loom in the months ahead, and the optimistic +3.5% to +4.0% GDP forecasts will prove too optimistic. While job growth has recently improved, the absence of wage growth, a likely weakening in personal spending and the absence of a revival in home sales activity this spring could translate to a worse job and retail-spending picture in the months ahead (especially relative to the more optimistic consensus expectations). I would note that not only is the near-term profit cycle at risk; from a longer-term perspective, earnings cycles seem to be occurring with greater frequency, and profits have been accompanied by more volatility and greater amplitude (peak-to-trough). Earnings peaked in 1990. The brief recession that followed resulted in only a modest drop in profits and in share prices. The next peak in earnings didn't occur for another decade (in 2000). Both profits and stock values fell more considerably than in the early 1990s, and it took only seven years (2007) for earnings and stock valuations to rise to another higher peak. Should the pattern continue (10 years, seven years and now four years), it implies that 2011 could represent the next peak in stocks and in earnings. There could be numerous reasons for this phenomenon. The timing of the Fed's tightening/easing actions and the role of financial "innovation" (and the proliferation of derivatives and growth in the securitization markets) are two possible explanations. Nevertheless, I see nothing on the horizon that changes my expectations that the profit cycle is more mature and will demonstrate more volatility than most expect.
Just as the earnings cycle is experiencing more volatility over shorter periods of time, so are Black Swans and tail-risk events occurring with greater frequency. Consider that three of the eight worst natural disasters in the last century have occurred since 2004. Or that the U.S. stock market has encountered 21 drawdowns of more than 20% over the past 30 years.
How Now, Dow Jones?Given the abundance of my concerns, what is an investor to do in a stock market that is so powerful in terms of price momentum and, for now, devoid of even the slightest corrections? My advice is to buy insurance (or volatility) -- it's cheap, more attractive on a risk/reward basis, less frustrating than shorting "the market" and, if timed well, provides huge upside. As an acquaintance in Europe said to me, shorting equities is like a "leaky water pistol," and employing the increasingly popular VIX tactic that follows is like detonating "two sticks of dynamite" in a dynamite factory. In visiting many European brokerages/funds over the past week in London and in Paris, the most common VIX trade that is being done is called the 1x2 trade. If properly implemented, the trade's value falls less than the VIX during nonvolatile periods and rises far faster than the VIX during times of volatility and stress. The worst case is when volatility rises only slightly and the further-out long calls fail to increase in value. Here is how the trade has been explained to me (note: A SocGen strategist has recently written up the trade):
- Find the sweet spot of the curve, which is usually eight to 15 weeks out to expiration, where "roll yield does not eat into your returns and you can still see an explosive upside to your investment."
- Sell an out-of-the-money call option on the VIX.
- Use the call premium (in step No. 2), and buy two calls that are further out-of-the-money.
- At the time, the three options are out of the "sweet spot" -- take them all off and put the options back on that reside back in the "sweet spot."
"You can either surf or you can fight!" -- Kilgore, Apocalypse NowThough clearly not as extreme as at its polar opposite and oversold condition at the market's generational low in March 2009, today's overbought market holds a new and different list of fundamental, geopolitical, technical, sentiment and valuation risks. At the very least, in these uncertain times, hedge or purchase protection (e.g., the VIX 1x2 trade). For, if not Apocalypse now, there is a risk of Apocalypse soon. Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.