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.
Uncharted WatersWhat 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. S&P 500 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.
- 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).
A Growing Bull Market in NegativityAs 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 TheoryMeanwhile 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.
ConclusionIn 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.