"The four most dangerous words in investing are 'this time it's different.'" -- Sir John TempletonWith apologies to Sir John Templeton, it is different this time after a decade of goings-on (though Rogoff and Reinhart would say that we have experienced eight centuries of financial folly!)."The biggest threat to advanced economies is that debt will accumulate until the overhang weighs on growth." -- Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial FollyThe one singular and consistent argument communicated by bullish investors is that stocks are cheap as measured against consensus 2011-2012 S&P 500 profits. While corporate profits are up substantially from recession lows and back to impressive and near-record levels, to a large degree, the factors that contributed to that growth could create headwinds to growth in the future. Below are three such headwinds (jobs, the deficit, interest rates) that have importantly contributed to growth over the past decade but, perversely, lie on the horizon over the next decade as headwinds. These three factors create a fallacy of composition in the way the bullish cabal look at today's economy. The modo hoc (or "just this") fallacy is the error of assessing meaning to an existent based on the constituent properties of its material makeup while omitting the matter's arrangement. In today's economy the fallacy of composition is that the very source of past profits and growth becomes a headwind to future profits and growth.
The above factors are important secular/structural headwinds that will weigh on profit growth and will likely limit stock market upside appreciation. They represent fundamental reasons why I believe that one shouldn't overly rely upon good corporate earnings (and an estimated 13x P/E multiple on 2011 S&P profits) in assessing the outlook for the stock market. Importantly, structural headwinds that adversely impact economic activity and corporate profitability have not been addressed by policymakers and, until recently, have been ignored by market participants. Instead, legislators (and investment managers) have seemed more interested in "illusionomics" (e.g., setting asset prices). Over the past 12 months, the comfort of rising stock prices has hidden a lot of sins. Unfortunately, this past week's GDP revisions and other economic releases have exposed a domestic economy that is more challenged than many had believed. The growth-deflating, nontraditional headwinds that have been born out of a decade of lending abuses, overproduction of new homes, excessive government spending, refusal to address our jobs deficit, and ill-timed, unfocused and misdirected monetary and fiscal policy are about to come to the fore. As a result of these factors (and others), an uneven and inconsistent growth path, not a smooth and self-sustaining growth path, seems the most likely base case for 2011-2012. This future profile of lumpy economic and profit growth doesn't preclude market gains in the months and year ahead. Contained current inflation (and tame inflation expectations), a market-friendly Fed, low real and nominal interest rates, healthy corporate balance sheets, stable bank swap and credit spreads, negative investor sentiment (as reflected in low invested positions of individual investors and the hedge fund community) and excellent profit and dividend growth (even in the face of sluggish GDP growth) are all constructive factors that support stock prices and likely diminish the case for material market risk from current levels. It is for these reasons that I believe the S&P 500 will be contained in the 1250-1350 range -- note: we have already moved well through the low end of my target -- over the balance of the year and will end 2011 about where it began on January 1, 2011. Nevertheless, the weight of the aforementioned headwinds certainly limits the market's upside. Our due bills are shortly -- er -- coming due. There is no such thing as a free lunch.
- The drag of structural unemployment: Since companies couldn't control the costs of raw materials, they have opted to improve productivity and cut costs primarily by reducing jobs or by making their current workforce work longer and harder. As economic growth decelerates, the drag of elevated and structural unemployment will serve as a constant headwind ahead.
- The drag of government spending cuts: Corporate profits are also up in part because of the ballooning deficit, as the government has overspent. So it follows that the necessary spending cuts (aimed at reducing the size of the deficit) will adversely impact prospective economic growth and, in turn, corporate sales and profits.
- The drag of future rate rises: Finally, corporate profit growth has been spurred on and elevated by the most aggressive monetary policy moves in history (quantitative easing and zero interest rate policy). The generational lows in interest rates have enabled corporations to roll over debt cheaply, have allowed consumers to borrow (on installment and mortgage debt) at unprecedented low interest rates and have kept government borrowing costs low relative to the size of a ballooning deficit. While all three borrowers have become addicted to low rates, it is not likely a permanent condition. Though it is clear that rates will be pegged low for at least the next year, it is unreasonable to expect interest rates to be low forever. The withdrawal from artificially low interest rates could be growth- and profit-deflating painful in the fullness of time.