Readers know that I have a bearish outlook for stocks on a medium term time horizon. However, it is always important to be aware of and to understand contrary arguments.
In this article, I will briefly review and evaluate the bullish case for stocks:
1. The U.S. economy is strengthening: The initial estimate of third quarter GDP was stronger than expected. Furthermore, in the last two months, most economic activity indicators from PMIs to employment data have been showing signs of acceleration.
The problem is that much of the recent acceleration is due to temporary factors. I have been saying for the past two months that U.S. economic numbers could probably get a temporary boost from a release of pent-up demand associated with the easing of Japanese supply-line disruptions as well as the alleviation of sentiment shocks. However, I believe that these positives will begin to wind down as soon as November 2011. By January of 2012, the U.S. economy will probably be decelerating significantly.
Just as the aforementioned temporary boosts wear off, the impacts of the world-wide economic slowdown will begin to manifest in U.S. economic production data. The initial impacts of the European crisis were felt via the effects of sentiment on consumption and investment. The impacts on production are lagged. The medium term effects will begin to manifest in slower production by early 2012.
I am not amongst the analysts predicting an inevitable recession in the U.S. However, I believe that the U.S. will be experiencing significant economic slowdown - with some risk of a shallow recession - by early 2012.
2. Corporate earnings are strong: U.S. companies are breaking records for profitability.
Actually, this should be a source of concern. S&P 500 profit margins are at historically high peaks. Third quarter results suggest that U.S. margins have probably peaked and have begun to taper off. Historically, once profit margins have peaked and begin to decline, major PE contraction tends to follow.
Furthermore, various reports, are showing that the rate at which companies are lowering guidance is accelerating notably compared to the 1st and 2nd quarters of 2011 - despite the fact that U.S. companies have been guiding estimates down all year. Goldman Sachs recently released Beige Book on corporate earnings is also painting a fairly dire outlook. Of particular concern in all of this is that the most cyclically sensitive companies, such as in the semiconductor sector, have seen some of the steepest reductions of guidance.
3. Valuations are cheap: Forward PE ratios are cheap on a historical basis, and particularly relative to interest rates.
Although this is true, it can be somewhat deceptive.
First, PEs tend to be lowest when earnings are at their peak - indeed that is how it is supposed to work. In this regard, it is a fundamental error to compare current PEs to long-term average PEs irrespective of where one is in the earnings cycle. Once one takes into account that S&P earnings are at their peak, or slightly beyond, U.S. PE ratios are pretty much in line with historical norms.
Second, and related to the above point, PEs are not really all that cheap on a cyclically adjusted basis. The most popular measure of cyclically-adjusted earnings is PE10, popularized by Robert Shiller. By this metric stocks are currently expensive. Having said that, I want to stipulate that PE10 is a seriously flawed metric and I do not recommend it. This metric is based averaging earnings over an arbitrary time frame (10 years) and adjusting those earnings in a manner that does not correspond to the historically observed behavior of earnings over long periods of time. My own measure of cyclically adjusted earnings - based on analysis of full economic cycles rather than an arbitrary number such as ten years - suggests that current PEs are right in line with historical averages. In other words, an analysis of cyclically adjusted earnings does not support the notion that stocks are particularly cheap. They are not expensive on a cyclically adjusted basis; but they are not cheap.
Third, valuation is not a useful predictor of stock market returns over 1, 3 or even five year time horizons. Valuation is only a useful predictor of returns over extremely long periods of time - and even then only when valuations have reached extremes. Since valuations are not currently at extremes by any measure the valuation argument is irrelevant.
Fourth, the interest rate argument is not compelling. Upon close examination, the data don't really show that PEs are always high when interest rates are low. What the data show is that PEs tend to rise in a secular fashion when interest rates are falling in a secular fashion. Interest rates are currently at levels from which they cannot fall significantly - therefore, by definition, interest rates are no longer in the midst of a secular decline. Indeed, under any scenario that would be favorable to stocks, interest rates must rise. Thus, from the perspective of secular interest rate trends, there is little reason to expect PE expansion. Quite to the contrary, as countries around the world apply aggressive monetary policy to jumpstart growth, secular inflation risks will tend to rise. Rising inflation on a secular basis is associated with PE contraction.
4. Europe doesn't matter to the U.S.: Some analysts have pointed out that U.S. exports to Europe comprise a tiny portion of U.S. GDP. From this, the analysts conclude that Europe is not really important to the U.S. economy or stock market.
The best thing that can possibly be said about this line of argumentation is that it is foolish.
First, well over 30% of S&P 500 sales and roughly 50% of earnings are from non-U.S. sources. The vast bulk of this is from Europe. And most of the rest of non-U.S. earnings that are not from Europe come from economies that are highly dependent upon the European economy for their growth.
Second, the danger that Europe poses to the U.S. is not via net exports - it is via the impact to the global financial system where European financial institutions play an enormous role. A financial system crisis in Europe could have an impact on the global financial system and economies that is at least as great, if not greater, than what occurred in 2008-2009 during the mortgage-backed security crisis in the U.S. The global economy depends upon a smoothly functioning financial system in order to grow. A crisis of major European financial institutions could literally bring global growth an abrupt halt.
Third, those that argue that emerging market growth can replace European growth simply do not understand how emerging market economies work. For example, Asian economies such as China are net subtractors to global demand. In other words, demand from the developed world fuels Asian economies; not the other way around. Without growth from the developed world, the gross demand added by Asian economies will only contract further, deepening the global recession. Furthermore, economies in Latin America and Africa are commodity dependent. Falling commodities prices can be expected to subtract from any gross global demand being added by these commodity exporters.
5. Depressed sentiment and underweight equity allocation: High levels of risk aversion and low equity allocations suggest that positive news flows could cause "sideline money" to pour into stocks.
In my opinion, this constitutes the most credible argument in favor of stocks.
The consensus regarding Europe is overwhelmingly bearish, and this has kept risk aversion high and equity allocations low. Any substantial reversal in the news flow regarding Europe could fuel a major rally as investors scramble buy to either cover shorts or increase equity exposure relative to benchmarks.
The problem with this particular argument is that it has become a bit long in the tooth. This factor was the basis for the October rally. This argument has also been the basis for aggressive calls by pundits to buy stocks ahead of a widely expected "Santa Claus Rally" as well as a "January effect."
Many short-term traders are positioned to take advantage of "seasonality." The problem is that seasonality is ultimately a very weak factor in the face of the sort of fundamental challenges currently being faced. For example, if the news flow is bad due to events in Europe or due to a failure of the Super Committee, critical technical support levels will be broken. Under such circumstances, the "stopping out" of these speculative long investors and traders will provide the impetus for a cascade of selling that would produce a sharp downward movement in stocks.
Conclusion
The bullish case for stocks is exceedingly weak from a fundamental point of view. The technical case is a bit more interesting given relatively light equity allocations.
Ultimately, the problem with the bullish case is that virtually all of the arguments that comprise it are absolutely irrelevant with respect to the main issue at hand. The main issue at hand is Europe. Arguments about, U.S. growth, last quarter's S&P earnings, valuations, technical formations and so forth are mere side-shows and distractions.
If Europe enters a full-fledged financial and economic crisis, the U.S. stock market will go down significantly.
Because I believe that the likelihood of a European crisis is high - combined with the fact that U.S. and earnings growth fundamentals will deteriorate significantly in the next six months - it is my expectation that the S&P 500 (^SPX) will ultimately decline to the region between 950 and 1,020. Where it goes from there depends upon the response of European policy makers once the crisis is underway.
As a result, it is my view that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing and/or holding equities - even those that appear attractive such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).
Disclosure: I am short various cyclically sensitive equity indices, QQQ and AMZN.
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