- Mr. Market has climbed a wall of complacency.
- There is a strong consensus about nearly every asset class.
- Historically stock markets are often unkind to consensus and to the changing of the Fed.
- Reward vs. risk has deteriorated for the U.S. stock market
- Beware: Risk happens fast.
There Isn't a 'Real Worry'A growing consensus, exemplified by Morgan Stanley's chief U.S. strategist, Adam Parker (a high-profile and self-confident bear up until the middle of 2013) and others, is finding it difficult to conceive of any negatives or headwinds to more gains in the global markets in 2014. "The only thing people are worried about is that no one is worried about anything.... That isn't a real worry," wrote Adam recently. I have learned over my stock market career that investors would far prefer to buy on price strength than on price weakness -- and that the crowd of investors typically outperforms the remnants as trends generally stay in place for extended periods of time.
A Weak Start to the Earnings Season
Surprise No. 2: Corporate profits disappoint.Slower global economic growth impedes corporate profit growth....As we approach earnings season, I estimate that 2013 S&P earnings approximated $108.50 a share.For 2014, the consensus estimates that the S&P 500 will achieve profits of about $116 to $120 a share. (Recently, those projections have been skewing higher and seem to be moving to closer to $120 a share.) My base case estimate is for $112 a share, a gain of under 5% (year over year), which is, again, below consensus.Slowing sales, a contraction in margins, the reduced influence/benefit from aggressive monetary policy and political uncertainties are some of the reasons why my baseline earnings expectation is for below-consensus 2014 S&P 500 profits. -- Doug Kass, " 15 Surprises for 2014"For those looking unsuccessfully for reasons to be cautious, we need only to look at the loss of momentum in corporate profit growth as we enter the new year. It is still early in the earnings season, and at the risk of negative data mining, thus far there have been a number of high-profile misses, including Citigroup ( C), Wells Fargo ( WFC), CSX Corporation ( CSX), Royal Dutch Shell ( RDS.A), Intel ( INTC), Fastenal ( FAST), Best Buy ( BBY) and many other retailers, Capital One ( COF), Ford ( F), General Motors ( GM), United Parcel Service ( UPS), Elizabeth Arden ( RDEN), etc. We should not be surprised -- indeed in my surprises for 2014 my No. 2 surprise (above) is that corporate profits continue to disappoint.
Profits and Margins Are Vulnerable
There are three important factors that have contributed to unusually high corporate profit margins -- all of which have begun to reverse.My reasons for this surprise have been explained extensively in "Flawed Case for a Bull Market." The reduction in fixed costs is more or less behind corporate America; interest rates have seen generational lows and, in the fullness of time (2015/16?), will be rising along with interest costs; and the lower effective corporate tax rates will likely be a thing of the past, as one day, our fiscal issues will have to be addressed by responsible policy and with the implementation of higher taxes to generate more revenue to the government. Profit margins are also vulnerable to a rising U.S. dollar, as a large percentage of S&P profits are the outgrowth of overseas sales.
-- Doug Kass, " Flawed Case for a Bull Market"
- Corporate interest expenses have experienced a marked reduction. Generational low interest rates have boosted margins dramatically. Over the weekend, Barron's' Randy Forsythe quotes MacroMavens' Stephanie Pomboy, who submits that lower rates have contributed more than $300 billion to aggregate corporate profits since 1997. In all likelihood, interest rates will rise over the next several years, perhaps materially, driving corporate interest expenses higher.
- Effective corporate tax rates have undergone a steady decline. Through offshore tax havens and other methods, corporations have consistently lowered their taxes. (Note: I fully discussed this trend earlier this year in "Addressing the Fiscal Cliff."). The reduction in corporate interest expenses (above) combined with lower effective tax rates have contributed to more than one third of the improvement in corporate profit margins. In all likelihood, tax rates will climb over the next several years, as our leaders in Washington, D.C., address the ballooning deficit.
- Corporations have reduced their fixed costs by cutting overhead, shedding jobs and making temporary workers a more permanent part of the workforce. Year-over-year productivity growth in third quarter 2013 was zero compared to +0.2% in second quarter 2013 and as contrasted to significant gains over the past five years. Productivity growth has slowed steadily over the past year, as year-over-year unit labor costs are now +1.9%. Corporations have cut to the bone, and productivity gains are in the process of reversing now.
There Is a Near-Universal View That Stocks Will Outperform Bonds in 2014
"The most unthinkable things (could) happen this year, and that is a basic pain trade that forces people into Treasury bonds." -- Jeff Gundlach, DoubleLineIndividual investors and portfolio managers (who are paid to worry) should always be concerned whether lying within consensus or outside of consensus. As we begin 2014, there rarely has been such a consensus with regard to the direction of the major investment asset classes -- namely, stocks up and bonds down. As well as equities delivering roughly a 10% return and bond yields rising modestly, there is a strong consensus about nearly everything else. The following views have been overwhelmingly embraced by the majority:
- There is risk to the upside for global economic growth.
- European stocks will outperform their U.S. counterparts.
- Japanese equities will outperform both Europe and U.S. markets.
- Developed equity markets will outperform emerging markets.
- The U.S. dollar will be among the strongest currencies.
- The Fed's tapering has been fully discounted.
- Industrial, technology and financial stocks will be among the strongest market sectors.
- Utilities, consumer staples and energy stocks will be among the weakest market sectors.
Price Is Truth, but Reward vs. Risk Has Grown UnattractiveMany argue that Mr. Market is climbing a wall of worry. I contend that Mr. Market is climbing a wall of complacency. There are numerous reasons for my downbeat market view this year -- one of my greatest concerns is that massive central bank liquidity has obscured price discovery. Each tranche of quantitative easing has resulted in a reduced effectiveness in fostering growth. Even Federal Reserve Bank of New York President Bill Dudley has recently stated that he has no idea what QE have accomplished. One has to wonder what will happen to the stock market in the process of bond purchases moving from $85 billion a month to zero.
- Corporate profit margins (70% above historical averages) are stretched to 70-year highs, so earnings are exposed.
- Second-half 2013 strength in domestic economic growth has been boosted by nonrecurring inventory accumulation. Some more recent signs (e.g., automobile sales, retail spending and housing data) suggest a deceleration in growth may lie ahead.
- The baton exchange from Helicopter Ben to Whirlybird Janet could be unkind to the markets. On average, a change in the Fed chair has resulted in about a 7% drop in the major stock indices.
- Quantitative easing may not be a continued tailwind for stocks. As Peter Boockvar wrote, "QE doesn't create a safer world, it is just a temporary high and the danger always comes on the flip side as previously seen.... QE puts beer goggles on investors by creating a line of sight where everything looks good, but the Fed's current plan is to end it by year-end."
- Sentiment measures are elevated to historically bullish levels. This is seen not only in the disparity between bulls and bears (in the popular surveys) but also manifested in the third-highest margin debt to GDP in history.
- Valuations (P/E ratios) rose by nearly 25% in 2013 vs. only 2% annually since the late-1980s.
- The Shiller P/E ratio is at or near historic highs (excluding the bubble of the late-1990s).
- According to JPMorgan, the S&P 500 is now more expensive on a forward P/E basis than it was at its previous peak in October 2007.
- Interest rates might pose more of a threat than is generally viewed. The rose-colored glasses being worn by investors might be cleared in the year ahead, as the withdrawal from QE and low rates might be harsher.
- A year ago, market enthusiasm was muted. Today there are no cautionary forecasts for the S&P for the next 12 months.
This column originally appeared on Real Money Pro at 8:32 a.m. EST on Jan. 21.