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Another year of voodoo economics?



January 19, 2012 – Comments (0) | RELATED TICKERS: EEM , TLT , GLD

Continuation of the bull market in equities that began in March 2009 seems dependent on further monetary expansion by "Helicopter Ben" Bernanke, but even that might not do the trick.

The "choochs" on TV are quick to point out that U.S. companies are continuing to report quarter after quarter of record earnings. There is reason to believe, however, that the glory days of this bull market are numbered. Pre-tax corporate profits now account for 13 percent of U.S. Gross National Income as of Q3 2010 (Haver Analytics). Such levels were last seen at the height of the dot-com bubble, indicating that the trend may be exhausted. The S&P 500 topped out in April 2011, and earnings from leading technology stocks have recently disappointed (i.e. Amazon, Apple,, etc.). Historically, the performance of leading equities has been an early indicator in subsequent broader market action.

We are at the point in the bull market when traders continue to buy stocks, yet don’t believe higher prices can be sustained. We continue to see P/E multiple compression with a different leading stock breaking down every day. Value-oriented stocks are outperforming growth stocks, which is typical of a late-stage bull market uptrend. Market participants falsely believe they can take shelter in the "least-worst" stocks and somehow dodge the dark clouds overhead. This is not true, and to my knowledge, never has been.

Even as the equity indices make new highs, risk appetite is waning. Margin credit contracted steadily through the second half of 2011, an early sign of a downturn. Volume continues to be anemic. JP Morgan's outspoken CEO Jamie Dimon was recently quoted as saying, "forget trading," referring to the decline in the firm's trading revenue.

Dow theorists (who study market cycles) will notice that utilities, health care companies, and other "low-beta" stocks have outperformed the market during 2011, which usually signals the end of a bull market. "At least I'm still getting my dividends," some will argue, but what good is a cherry on top of melted ice cream?

The secular outlook for growth in the United States continues to be bleak, mostly because of an aging population of baby boomers and unsustainable levels of debt with limited appetite for more. In the U.S., total credit market debt is somewhere in the neighborhood of 350 percent of GDP, a figure that is little changed since the financial crisis and is not different from many European nations. 

The U.S. dollar’s weakness reflects the fact that gold has been the leader of the "bull market" we've had since March 2009. The yellow metal, called "the ultimate bubble" by billionaire investor George Soros, has sold off significantly since reaching an all-time high of $1,900 an ounce last year. Since then, the dollar has strengthened, as is natural when high debt levels favor delevering.

U.S. stocks are substantially overvalued by fair measures of book value and historical dividend payouts. Long-term Treasuries are also overvalued (after a historic run in 2011), and may decline due to unexpected inflation. Limited-duration bonds of only the highest quality may be the most attractive assets going forward.

Though new highs are possible in 2012, a 50-percent decline from the S&P 500's April 2011 highs should not come as a surprise either. In fact, the Federal Reserve is already preparing for such a scenario with its recent round of bank stress tests that will be published in March.

Meanwhile, global growth estimates are being revised lower.

We continue to hear a lot about the potential for "emerging markets decoupling" from developed world equities. But as long as the European banks are the primary lender to the emerging markets, this reality remains a grim possibility. Stock pickers might be able to find hidden gems, however.

Still, divergences between U.S. and European equities are at extreme levels. Arbitrageurs are likely to view this as an opportunity to go long on Europe's extreme pessimism and short on the U.S.'s irrational optimism that it can somehow dodge the global slowdown in growth (and other bad outcomes).

Commodity exporting nations (i.e. Brazil and Russia) should be avoided in a deflationary scenario, where the price of commodities could decline substantially as the U.S. dollar becomes king.

We also mustn't dismiss the effect of election-year politics on financial markets, which is of course difficult to predict. Commodities "permabull" Jim Rogers, who cofounded the Quantum hedge fund, argues that presidential elections in the U.S. and France will lead central banks to flood markets with liquidity to make everyone "feel better".

The Federal Reserve has made no indication that reflation is on the horizon, however. Interest rates are at historic lows, so it will be a hard sell that interest rates need to move lower to stimulate borrowing. The Fed has documented internal dissension about its policy actions, and it seems satisfied with the current level of economic activity. We must also remind ourselves that the Treasury market is the Fed's source of power. The extent to which the creditworthiness of the United States is questioned by rating agencies, creditors (i.e. China), and the public at large could determine the Fed's next course of action.

Many market participants believe Chairman Bernanke is somewhat of a magician (Fig. A), and can move markets with the flick of a wand. The Federal Reserve does have the power to create credit, but cannot create the demand for it; only positive social mood can influence the demand for borrowing. In other words: you can lead a horse to water, but you can't make it drink.

The classic bell curve of probable market outcomes now incorporates the "fat tails" of two exceedingly bipolar outcomes - one being reflation (via the "printing press"), the other being deflation (due to delevering). Right now, U.S. markets appear to be pricing in reflation; however, the stock market is technically damaged and the long-term outlook is still bearish.

Growth investors who have been invested since March of 2009 should use the current environment to make tactical exits from the stock market. Any new purchases of equities should have abnormally high "margins of safety" from a valuation perspective.

For those who prefer to remain fully invested, there are options. If you must be long, focus on value opposed to growth. Deep values in cyclical sectors may be attractive (if the economy picks up), along with a very select few banks that have pristine and transparent balance sheets with a low percentage of nonperforming loans. Technology shares are in bubble territory, and should be carefully monitored or avoided.

One figure that alarms me is the extreme optimism among individual investors, nearly fifty percent of whom are now bullish (ten percent above the long-term average). On the other hand, bearishness among individual investors is near a seven-year low, according to the well-known sentiment survey conducted by the American Association of Individual Investors. Such herd-like mentality is historically witnessed at major turning points in the stock market.

With so many uncertainties in the macroeconomic environment, now is the time to focus on a return of your investment, as opposed to a return on your investment, to borrow a Will Rogers line. Some may find "cash in the mattress" is the most attractive option as the prospect for deflation looms large. This behavior doesn't exactly favor stocks.

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