This column originally appeared on Real Money Pro at 10:12 a.m. EDT on Aug. 13.NEW YORK ( Real Money) --
"One of the most helpful things that anybody can learn is to give up trying to catch the last eighth -- or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent."To be sure, the last six weeks (and, for that matter, most of 2013) have not been fun for the ursine crowd, a fraternity that unfortunately includes me as a member. Once again, as has been the case throughout the market advance since the generational low in March 2009, the bullish crowd has outsmarted the bearish remnants. I have learned over the years that there is only one side of the market -- it's not the bull side or bear side; it's the right side. But Mr. Market is never obvious. He is designed to fool most of the people, most of the time -- and even as I write today's column, we meet this morning at close to the market's all-time high. There is certainly no arrogance in my bearish/top view expressed today, as some of my previous market forecasts have been wrong-footed in a bull market that has been a buy on every dip. Similar to Johnny Depp, who has experienced several high-profile and recent movie flops, I have been chastened (and I am poorer) based on my mistaken market views throughout this year.
-- Jesse Livermore
"Do not dwell in the past; do not dream of the future; concentrate the mind on the bagel and lox on the plate." -- Grandma KoufaxBy the same token, Grandma Koufax used to tell me that it is unproductive for me to dwell in the past. (She also told me to never put jelly on matzo.) Back in late May, I covered most of my shorts (with the S&P 500 at a 1560-1575 level), but I have been slowly expanding my net exposure throughout July and early August.
"The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don't waste time. When a stock moves below a mental-stop, sell it immediately." -- Jesse LivermoreDuring the last six weeks' market rally I have tried to manage risk, as I continue to remain negative on the market outlook. Still, my concerns are that:
- the Fed is about to taper; and
- the domestic economy will not be able to hold up in the face of a higher cost of capital (and rising interest rates).
Multiple Expansion Has Fueled the Rally in Equities
The S&P 500 index has increased by over 34% since the beginning of 2011, of which 28% has come from multiple expansion. During the same period, growth in corporate earnings has slowed. The trailing 12-month earnings for S&P 500 companies rose 2.4% in 2012 and another 2.5% for the first seven months of this year, registering the slowest earnings growth in non-recession years since 1998. Without renewed earnings growth, a continued rally in stocks driven by multiple expansion may be not sustainable. -- Scott Minerd, Guggenheim PartnersIn formulating my bearish opinion, it is important to recognize that most investors and strategists have made little change in their economic and S&P forecasts for earnings in 2013-2014, yet (as described above by Guggenheim Partners) they have comfortably accepted the rise in valuation from under 14x to over 16x this year and have almost universally stepped up their S&P price targets. This P/E expansion has occurred despite China growth issues/questions, a (market-unfriendly) trajectory of higher interest rates, evidence of a growing ineffectiveness of quantitative easing, the heavy weight of upcoming decisions in Washington, D.C., and disappointing bottom- and top-line second-quarter 2013 results (and guidance).
In other words, the market (S&P 1690), now standing within 1% of an all-time high, has been forgiving and has looked toward the future with optimism. Based on the concerns and headwinds discussed this morning, I would contend that the market's P/E multiple now likely resides near the high end of the range expected in 2013. Below are my top 10 reasons why the market may have peaked for the year. (No. 1- No.6 are fundamental challenges, No. 7-No. 9 are technical issues, and No. 10 is concerned with sentiment.) 1. Rising interest rates pose more of a threat to growth than many believe. At the core of my pessimism is that the U.S. economy will not likely be able to hold up in the face of an increase in interest rates and a higher cost of capital. The Fed's four-year-plus strategy of quantitative easing is growing increasingly more ineffective -- it has neither created jobs nor stimulated innovation. (Apparently, the San Francisco Fed now agrees.) Kick-starting asset prices and the production of economic growth of only 2% (in real terms) underscore the failure of trickle-down monetary policy and simply do not guarantee a self-sustaining recovery that will continue under its own momentum. As I have previously written, the stock market, the consumer and the corporate and public sectors are addicted to low interest rates. To date, the market has comfortably absorbed a doubling in the five-year U.S. note yield and a 110-basis-point increase in the 10-year U.S. note yield. The next rise in rates, however, will likely exact more of an economic and market toll (particularly on housing). If you don't think the market is the beneficiary of quantitative easing and you think tapering is nonevent, consider that the Fed has printed $600 billion of new money this year. This has generated only a 1.5% increase in GDP or $300 billion this year. But thus far in 2013, there has been a 20% rise in the value of U.S. stocks -- that is a rise of $3.5 trillion (on a base of $20 trillion total market value). So, a change of policy (i.e., tapering), is more significant and impactful than most argue. The "taper is not tightening" argument is semantics because less asset purchases equals less accommodation. Moreover, it is now the markets that have tightened policy over the last two months, as the Fed has begun to lose control of rates. (Note: The yield on the 10-year U.S. note resides at 2.66% this morning, only a few basis points from the recent high yield. In my judgment we are close to the line in the sand, where rates will adversely impact economic activity.)
2. Economic fragility. The recent data indicate that the domestic economy is growing moderately but steadily, but job growth is weak in quality, retail sales seem to be stalling, automobile sales have essentially flatlined since November 2012, and housing appears to be pausing (as measured by lower purchase applications, slowing traffic, reduced order books and rising cancelations). I challenge anyone (excluding the economic perma-bulls) to say (with confidence) that the U.S. economy is at escape velocity. I don't believe it is self-sustaining without the benefit of continued quantitative easing. As expressed earlier, any further increase in interest rates will be a headwind to growth. 3. The economic prospects for China, the straw that stirs the drink of global growth, are uncertain. I am not only suspect of publicly stated China growth rates but I am increasingly concerned with the rapid pace of credit growth, which has been increasingly sourced from the more risky and less transparent Chinese shadow banking sector. China's credit growth relative to its GDP growth has been too rapid, so the country's leadership is committed to slowing credit. This raises the risk of a banking crisis and subpar (5% or less) real economic growth. This downturn in growth will likely have a systemic financial impact on China's banking industry (which could feed into non-Chinese banks), global economic growth and on the pricing of risk assets. (Note: I would recommend both Goldman Sachs' recent "Top of Mind" and Hedgeye's Moshe Silver's column in this week's Fortune for lengthier discussions of this issue.) 4. An expected 2013 tapering is likely a policy mistake. I anticipate a September tapering despite the economy still growing at less than its potential. In listening to the Fed fiesta over the past month, it appears that most Fed members want out of quantitative easing for two basic reasons: 1. It is increasingly clear that QE is having a reduced or more marginal impact on growth; and 2. it is also clear that some feel exiting a $4 trillion balance sheet will be a challenge. This could be a policy error, especially if consensus and Fed economic projections are wrong-footed, as I think they are. If I am right, investors will begin to see tapering as premature relative to economic activity. Though tapering has been well-telegraphed and should start moderately -- let's say a $15-billion-per-month reduction from $85 billion -- if I have to quantify, I would guess that the S&P falls maybe up to 50 points in anticipation of it. I recognize that though tapering lies ahead, tightening does not. That said, corrections can occur anytime, despite quantitative easing and despite zero interest rates as far as the eyes can see. Look at the weakness in the Nikkei. The hedge fund community's favorite regional stock market is almost 10% off its high despite even more expansive quantitative easing than in the U.S.
5. The Fed head selection represents a more significant market event than consensus believes. My money is on Larry Summers. The selection of Summers (the favorite) or Geithner (a very long shot) could cost the S&P something like 50 points, while the selection of Kohn or Yellen (second favorite) could be a marginal positive for the markets. Though Summers has broad experience and is intellectually gifted, he would probably be difficult to work with, and the reduced transparency in a Summers-led Fed would likely increase asset price volatility. Both Yellen and Kohn are as qualified intellectually/academically and understand the workings of the Fed as they have been there forever. Also, they are highly respected by the other Fed members. 6. Politics will return to the front burner in the coming months. The September-October political agenda is lengthy, including the debt ceiling, government spending and immigration, tax and government-sponsored enterprise reform. Though market participants have become inured to the nonsensical rhetoric, a lengthy fight and impasse could again weigh on consumer and corporate confidence as it has previously. 7. The bull market is long in the tooth. We now lie almost 54 months from the generational low of March 2009. Over the past six decades, the average bull market has been about 43 months, the longest bull markets have lasted 56 and 60 months. (Note: The longest bull streaks didn't face the structural economic headwinds that we face today; they had long runways of growth and technological innovation ahead of them.) Moreover, the intermediate leg of the bull market, which commenced in November 2012, has already climbed by almost 30% in only eight months. 8. Changing leadership seen as a negative. As I recently wrote, sector/group leadership changes are typically a negative sign for markets. (And, as Jim Cramer suggested on Real Money yesterday, "It's hard to find leaders.") Former market-leading financials ( Financial Select Sector SPDR ( XLF) is -4% off its high), housing (the most distributional pattern, with the iShares U.S. Home Construction ETF ( ITB) -18% off its high), health care and biotech ( iShares Nasdaq Biotechnology Index Fund ( IBB) is -4% off high) sectors are all extended and in recent weeks have begun to show signs of lost momentum, underperformance and possibly distribution. At the same time, materials have improved, but few others have, suggesting that a broader-based (and healthier) sector rotation is not yet in place.
9. Breadth weakens. Though most indices are within 1% of an all-time high, new peaks have not been confirmed by breadth or by new 52-week highs since mid-July. This is particularly true with regard to NYSE (all issues) breadth, which includes a number of bond-equivalent stocks/ETFs. The same non-confirmation has developed in the Nasdaq Composite and S&P 600 indices. Relatedly, the McClellan Summation Index has rolled over (Hat tip, Chuck Berry!) and could go down further before even reaching a moderate oversold status. 10. Valuations are stretched. As I expect only 2%-4% growth in S&P earnings for 2013 and 2014, any further stock price gains are very dependent on improving valuations and multiple expansion. S&P profit forecasts are for $107 a share for 2013, $110 a share for 2014, and $114 a share in 2015. Given these estimates and given the deep structural global economic issues (disequilibrium in the U.S. jobs market, continuing deleveraging, etc.) I deem an appropriate/reasonable P/E as between 14x to 15x (slightly under the five-decade average of 15.2x), a contraction in valuations from current levels Finally, let's look at the "Shiller P/E ratio." My friend/buddy/pal FT Advisors' Brian Wesbury recently wrote the following:
In terms of market calls, few academics or economists can match Yale University economics professor Robert Shiller. In his 2000 book, Irrational Exuberance , he argued that 10-year averages of corporate earnings smoothed out the ups and downs of the business cycle. Then, using this "cyclically adjusted" level of earnings and comparing it to current stock prices, he claimed to generate a better version of the P/E ratio. Shiller's timing couldn't have been better. The "Shiller P/E ratio" was at an all-time high in 1999-2000, a clear signal of overvaluation and a reason to sell.Today, Shiller's valuation work says that stocks are back to being in overvalued territory. At the end of July, Shiller's ratio was 23.8, the highest since 2008.