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A Summary of My Bearish Thesis for US Stocks



January 24, 2012 – Comments (11)

So I thought I'd offer an overview of my bearish thesis of the market as a whole. That isn't to say that there aren't good opportunities available but I believe better opportunities are coming.

European sovereign Debt

As if we hadn't heard enough about this issue... The reality, of course, is that there's a lot of debt that needs to be repaid or refinanced and it's questionable that those damned PIIGS will be able to pay it back or refinance it at interest rates that it can manage to pay without having heavy damage.

In spite of this it may not have a dramatic effect on the US stock market. At least I could imagine a European fallout harming European demand and perhaps some tightening of credit markets but having only a marginal impact on the US economy and US buisness. But it could very well be much worse. As a result this is a reasonable uncertainty here that could be damaging to the stock market as a whole and cause a major selloff (for a variety of reasons including economic downturn and possibly another US recession.) So I'm leaving this concern on the table.

And it's not just sovereign debt. It's that the European banks have all this crap on their balance sheets. And haircuts will have to occur. The PIIGS collectively have over 2 trillion euros (about $2.75 trillion) in debt. And they have zero capacity to print their way out of it since they're on the "euro standard".

So deleveraging is a necessity imo. (By deleveraging I refer to some process whereby "DEBT to GDP" or some similar metric declines.) And there's historically been 4 ways to deleverage:

Two ways results in lowering debt (numerator):
1) Default/Restructuring
2) Austerity

Two ways are due to increasing GDP (denominator):
3) Real economic growth
4) Inflation

Number 4 is not possible since they are on the euro standard (unless they get off the euro standard which is an entirely different bag of worms). 3 is unlikely since they'd have to run large trade surplusses (with whom?)

They've been trying 2 without much success. That leaves 1 unless someone can come up with some alternative. And we know that will be painful one way or another (all scenarios are painful except for possibly number 3).

Private Debt - the much ignored problem

But beyond sovereign debt problems, something that doesn't get enough discussion is private debt.  The reality is that private debt here in the US is still way above levels we saw in the roaring 20's. See the red line in Figure 1:

If you look at Figure 2, you can see there's a problem in Australia as well. And this is a common problem in many regions of the world.

The reality is that we are in the middle of a deleveraging recession. Many sectors (public and private) in various parts of the world are in one. That's not like the recessions we've seen in the recent past. The last deleveraging recession we really saw in the US was the 1930's.

Our GDP growth in the US over the last 30 years or so has been a result of increasing debt levels. We bought cars on credit, houses on credit, tv's on credit, you name it we bought it on credit. And debt isn't necessarily a bad thing provided that we have the cash flows to maintain that debt. But we've already tapped the equity in our homes and unemployment is still pretty high. Where's the money going to come from? We need income to service that debt. And servicing of debt takes away income from making purchases so where's the GDP going to come from?

We can't keep increasing debt levels at a faster rate than our income levels. Something has to give. So there's a geniune concern that we're going to see slow/nonexistent economic growth. And we aren't used to that. Expansion of debt skyrocketed in the 80's. And that worked out great because it allowed US workers to have their salaries stuck in the 70's (ignore the CEO's who have increased their income about 10 fold in real terms) but we continued to increase the amount of items we purchased. This is stuff we simply can't afford (the CEO's can but let's ignore them for the time being.)

All of this means that companies are going to have a hard time selling products and the high margins we are seeing will have to come down (cue Jeremy Grantham's "revert to the mean"... more from him later.)

Baby Boomers and the Stock Market

But aside from all of that there are other reasons to think we've got it ugly. Consider the Boomer Effect.  Here's a study put out by the San Francisco Fed:

They find a relationship between the MO ratio (ratio of people in their 40's to ratio of people in their 60's) and the PE ratio. The idea is that people in their 40's are in their financial prime, accumulating assets (particularly stocks) while people in their 60's are retiring or preparing to retire so they are liquidating assets (stocks) to pay expenses or transfer to less risky assets. So the MO ratio should be an indicator of the ratio of people dumping money into stocks to those pulling money out of stocks.

It should come as no shock that when you dump money into the stock market prices go up and when you take money out prices go down. And that's precisely what they find.

Based on their model, they project the next 10 years to see a 13% decline. (They assume earnings grow at 3%.) After you factor in dividends (which are at about 2%) you might do slightly better than even. That would amount to less than 1% annualized returns. Those 10 year treasuries don't look so bad after all! (As a side note, I think they're ugly too. I don't know how long they can keep rates that low but I'm not going to risk it and find out the hard way.)

The Stock Market from a Valuation Standpoint

Aside from all of that valuations are high. Shiller PE ratio is almost 22:

Historical average is just above 16 (which is about what Benjamin Graham recommends as a place to buy under). Dividend yields are less than half historical levels. If you assume the less than 2% dividend yield plus an historical real growth rate of 1%, you'll do about 3% real returns over the long term. So stocks aren't that greatly priced. Obviously if you're investing in higher quality/better value stocks, you should do much better than this but it indicates that the market is due for a real correction.

But what if we see a real correction? We haven't had one in a while.

Historically post-bubble periods resulted in an average of 14 years below previous trend. The whole idea that markets rally after a drop off of price is a more recent phenomenon (I wonder if that relates to the expansion of debt we've seen? inquiring minds want to know). If that were to occur again, we'd get something like what Jeremy Grantham predicts:
(You can also find this at

I don't know if Grantham's scenario will pan out or not. But I think 800 for the S&P 500 is a much better level for real investment returns than the current levels.

For those reasons I think 2012 may turn out to be a great year for buying quality stocks. But I'm patiently waiting for better prices to come.

11 Comments – Post Your Own

#1) On January 24, 2012 at 9:58 AM, walt373 (99.84) wrote:

Good points. The market hasn't been cheap in ages. I'm talking old school, single digit P/E cheap. People seem to think we'll never see them again.

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#2) On January 24, 2012 at 12:08 PM, PeteysTired (< 20) wrote:

Central banks and gov'ts around the world will ensure inflation.  Face it, that is how they make money over time.

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#3) On January 24, 2012 at 12:58 PM, leohaas (30.08) wrote:

You are making excellent points. I believe they will hold true long-term if you are talking about real (post-inflation) returns.

That said, it isn't necessarily true for the mid-term or short-term. Other factors play a role, and some may play a large role. So to draw a conclusion for 2012 based on your arguments is a stretch. You are likely to be right if we use the end of this decade as the horizon, but the shorter you pick the end of your forecast, the less likely you will be right.

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#4) On January 24, 2012 at 1:58 PM, jwebbzor (< 20) wrote:

I don't think we will see bargain P/E ratios for a long time. Too many people are trying to be the next buffett... Too many hedge funds with billions of dollars are in the market. The financial sector is overpriced because too many people have chosen it as a career. Like you said, more money being pumped into the markets makes the price go up.

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#5) On January 24, 2012 at 3:12 PM, Option1307 (30.65) wrote:

Not sure I agree on seeing 800 anytime soon, but nicely written. +1.

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#6) On January 24, 2012 at 3:41 PM, Hawmps (< 20) wrote:

I think you actually make a good case for taking the next 10 years or so to load up on solid dividend paying stocks and reinvesting said dividends to buy the shares the boomers are selling.  As prices decline, as you say while boomers are doing the sell-off, these companies would be more affordable and further compound the accumulation of shares bought with dividends.  That process of boomer money leaving the market will slow eventualy and I have a hard time believing that following generations would not be putting earned money back into the market helping to drive prices back up.

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#7) On January 24, 2012 at 9:48 PM, walt373 (99.84) wrote:

I feel that you can't classify a bottom as a "generational" low until there is long-term revulsion in the market. The 2009 low was panic selling, not revulsion. Many investors were still hopeful and they were vindicated after a few painful months. A true bear market bottom does not occur until everyone gives up on stocks, swear them off forever, and warn their kids not to gamble in the market.

When that happens, "conservative allocation" retirement portfolios won't be 50% allocated to stocks and you won't have the mass participation that you're still seeing today. I mean stocks have always given very good returns over long periods of time. But where were the people chanting "stocks for the long run" before the past twenty years? I'm not saying this will happen any time soon, but we'll get back there eventually. You have to think about it if you really want a big picture view. Everything is cyclical, remember that, and some cycles bigger than others.

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#8) On January 24, 2012 at 10:53 PM, awallejr (38.93) wrote:

I think the average boomer has left this market already along with the average retail investor.  If the crash of '08-'09 didn't scare them away certainly the ridiculous volatility of 2011 did.

With that said I don't see a reason for another market crash. Things have been slowly healing.  Last year I kept hearing gloomers like Roubini predicting double dip recession for 2nd half of 2011.  What  happened?  We had steady albeit small improvement.

We aren't losing 800,000 jobs a month now.  We are gaining 200,000.  Nothing spectacular, but a gain nonetheless.

The economy is doing what I said it would do years ago, improve slowly.  And it is no thanks to Congress, but to Ben Bernanke, a man many ridiculed on this site.

Expectation is the US GDP to improve perhaps 3%.  Yet if we actually do have a housing bottom and improvement that number can increase over the years.

It is the stalemate in Congress that is a concern.  Bernanke can only do so much from a monetary point of view.  But he NEEDS help from the fiscal side. Unfortunately I don't see that happening until November when the voters vote. Personally I suspect Obama will win re-election and Republicans will lose seats since they are pushing an agenda that just does not appeal to the majority.  Time will tell.

But I still see many mlps, reits, bdcs and quality companies paying higher dividends than 30 year Tbills.  I don't see the market expensive yet, tho a correction is always in the cards.

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#9) On January 24, 2012 at 11:09 PM, TempoAllegro (< 20) wrote:

My comments:Very interesting post. My own reaction is to have as little personal debt as possible and to live well below my means. I also want to have enough cash in various currencies, banks, and counties, if I can, and stocks in precious metal miners and dividend payers.Do you agree that precious metals are a good place to be right now? Some miners do offer dividends.Other commodities of interest to me include oil and agriculture. These seem to skirt some of the issues you discuss since they will have international customers. 

Some additional comments – About your 4 ways of deleveraging, perhaps there are other ways you have not thought of here.But assuming these are the only four, then austerity has been much maligned but not really been given time to have its effect. I did not quite get why inflation is not possible, but let’s put that aside. Real economic growth – from whom? Are you serious? Germany has been doing this well for quite some time and I think we just need to look at them as an example. Sure, many sales are going to China, but there will be other emerging economies such as India, followed in short order by places like Thailand and Indonesia in the years to come. There are going to be plenty of places to export to!In short, your conclusion is depressing, and while I do agree the scales are tipped in favor of at least more turbulence in the year to come, I would say long term, especially for the USA, things will stabilize. 

Private debt. Yeah, I think that we have been relying too much on the American consumer for too long. If Americans wise up, they would not spend what they do not have, and realize that we are not going back to the way things used to be. We need to reduce that two-thirds of our economy based on consumer spending to much less than that. Increasing exports should be the way to go. Unless someone comes up with a better idea, like colonizing Mars. 

I think the baby boomers info was the most interesting part of your post. However, this was not the first time I had seen the info – just has been a while. Well, for one thing, these guys could give some of their stocks to the next generation. Another thing is they could sell their stocks to foreigners. The market does not HAVE to go down because of demographics. 

Shiller is well-known and I am in no position to argue. But we could likely find another expert to argue the opposite position. If I am not mistaken, Bloomberg TV did just that recently and got both Shiller and another expert saying pretty much a contrary position. Wish I could remember the name of the other guy. Oh well – experts will say what they will, but they ARE wrong sometimes and it is still not a reason for us to turn off our own brains and figure it out on our own. Besides, I think the Fool has a special viewpoint on experts. Enough said.

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#10) On January 25, 2012 at 10:59 AM, somrh (82.85) wrote:

I don't have too much time for comments so forgive me having to keep this much shorter than I'd like...

@ leohass, I agree that I can't conclude that it will occur in 2012 which is why I did emphasize the "may". I think the Europe event is likely to occur in 2012 (walt373 has an excellent post outlining this point) and that could very well be a catalyst for a drop in US stocks.

@ Hawmps, I'm a fan of dividend stocks (after all, what's the point in owning a stock if all it does is just sit there? why not pay me some money). I have intentions on loading up on those but I'd like to find maybe a couple of potential growth plays (Fisher-Lynch style) to mix it up.

@ awallejr, I've seen some of those numbers (and some criticism of those numbers) so I'm not entirely sure what to make of it. For example, I don't know what to make of employment numbers. I know unemployment is still high and understated and underemployment is another factor that can't be ignored. I think some of the underlying problems are still there (particularly the debt problems).

For example, if I all of a sudden get a job (at income that is probably less than what I was making before when I accumulated this debt) how are the debt concerns still not a really huge problem? 

I think Bernanke has done a good job of not letting debt deflation take hold but I'm not convinced as of yet that we won't see a decade that's more or less like Japan (they had 2 decades, no?). (I have plenty of reasons to criticize Mr. Bernanke but that's an entirely different topic.)  

@ mungermaniac,I have no idea on precious metals because I have no idea how to value them. I'd prefer resources that are more critical to industry but I'm not sure how to invest in them. I've seen some interesting critiques of mining companies as an investment vehicle here on fool so I'm a bit skeptical. Grantham has an excellent couple of pieces on natural resources (I think they were from 1st and 2nd quarter 2011 - see GMO, for example, is optimistic on timber which is relatively easy to invest in.

As for the 4 ways of deleveraging (and due to being short on time) I'll refer you to one of my sources:

The study is a look at deleveraging in the post Great Depression world and is a summary of the data. Much of it derived from data accumulated by Reinhart and Rogoff in their excellent book This Time is Different. (The 4 categories may have originated there but I can't recall and don't have my book handy.)

My comments about inflation were a result of the fact that Greece, Portugal, et al, can't print their own money; that's determined by the ECB. I believe a bailout would likely result in inflation in the eurozone but I believe that would classify as "default" under their categories. Contrast that with, say, the US or Japan (both have high Public Debt/GDP) and we can simply print out way out of it. So inflation is an option for us, under our control. That's not an option that's, say, at Greece's direct disposal being on the "euro standard".

Assuming austerity could work given enough time, I don't think Greece has that much time. All austerity has done in Greece has lowered GDP (due to decreased govt. spending in a country that is already in recession) and hence lowered government revenues. Greece, I suspect, will default (one way or another) this year. That's not much time for austerity to work. 

It could very well work in the US. (The US during the Great Depression deleveraging was actually an example of all four according to McKinsey IIRC.) We have lots of options. 

The "grow real GDP" out of debt was a pretty rare form according to the literature. Most of the examples, IIRC, were from emerging economnies that could enter trade surpluses with other nations. I frankly don't see that as an option for the PIIGS.

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#11) On January 27, 2012 at 11:36 AM, walt373 (99.84) wrote:

Good stuff, somrh. Austerity can work, but much less likely during a recession and without a trade surplus, and Greece obviously has both those problems. And if you want every country to do it together, that seems completely hopeless to me. But Europe is quickly recognizing that austerity is actually counterproductive right now. What they need currently is the opposite of austerity - stimulus. Recent comments from leadership in Italy and Spain signify a changing sentiment toward austerity. This could be bullish or bearish, depending on how Germany reacts.

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