Doug Kass - 12 Big Picture Factors

Doug Kass recently wrote a piece for TheStreet.com identifying "12 Big Picture Factors"that may weigh on the markets and the economy. 

First, a little background for clarity. Historically, the economy and the earnings generated by corporations have a highly correlated relationship as shown below. Since it is consumption that comprises 70% of the economy, and corporate earnings are a function of the underlying consumption, the relationship makes complete sense. Not surprisingly, corporate stocks prices have appreciated by roughly the same amount as well. 

However, over the last six years the Federal Reserves monetary interventions have skewed that relationship. Stock prices have surged while underlying economic growth has remained fairly stagnant. 

As Doug Kass noted:

"The U.S. stock market has lived a charmed life since the Generational Bottom in March 2009. Corporate profits have risen, inflation has been quiescent and valuations (price-earnings ratios) have expanded as stocks have more than tripled, while rising geopolitical tension, sovereign debt issues and other macroeconomic concerns have been ignored and dismissed.

How forgiving has the market been? The steady rise in stock prices has occurred despite a 1% annual shortfall in the rate of global Real GDP growth in each of the past three years and with consensus forecasts for 2015 S&P 500 earnings dropping from over $135 per share to below $120 per share in the last nine months."

The detachment of the financial markets from the underlying fundamentals is a hallmark of historical market peaks. The belief, and the ongoing rationalizations, of why "this time is different." Historical evidence clearly shows that it has not ever been the case.

However, Doug points out 12-Big Picture Factors that are worth considering when weighing the bull case.

1. Multiple and unpredictable outcomes: There have likely never been in history more numerous market and economic outcomes, some of which are adverse and most of which are being ignored by market participants.
2. Stuff happens: Black Swans appear to be happening with greater regularity.
3. Weak growth ahead: Central bankers' aggressive monetary antics have only produced subpar global economic growth.
4. Borrowing from the future: Zero interest rate policy (ZIRP) has borrowed past and present sales from the future, underscoring the challenge of future economic growth.
5. Unknown consequences of policy: No one knows the consequences of an extended period of ZIRP "punch bowls," which often result in aberrant behavior and hangovers.
6. Making no sense: Indeed, if there were no consequences to zero interest rate policy, interest rates could have been held at zero forever – in the past as well as the future.
7. Stop looking up, start looking down: Monetary overkill (in duration and in the level of interest rates) may produce the adverse consequences of malinvestment and has resulted in the hoarding of cash and reduction in spending by the disadvantaged savings class.
8. Uneven and less dependable growth: The "exclusive prosperity" of the haves (vs. the have-nots) is politically unstable, leads to more uncertainty (and unexpected outcomes) and will likely have a negative and more volatile impact on our social system, on the global economy and on our markets.
9. Tom Friedman has the ticket: Our world has never been more flat, more networked and more interconnected; as such, the notion of an "oasis of prosperity" is not likely rooted in fact.
10. Trouble ahead, trouble behind: Terrorism and religious radicalism (political and economic) will be more of a threat in the future than in the past.
11. Treacherous technology: In a paperless (and "cloudy") world, investors and citizens are not likely as safe as the markets assume.
12. Lack of coordination: Geopolitical coordination is at an all-time low and isolationism seems likely to be a mainstay in the time ahead.

The reality is, like dominoes, that once one of these issues becomes a problem, the rest become a problem as well. Central Banks have had the ability to deal with one-off events up to this point by directing monetary policy tools to bail out Greece, boost stock prices to boost confidence or suppress interest rates to support growth. However, it is the contagion of issues that renders such tools ineffectively in staving off the tide of the next financial crisis.

One thing is for sure, this time is "different than the last" in terms the catalyst that sparks the next great mean reverting event, but the outcome will be the same as it always has been.

David Rosenberg - Equities In The Long Cycle

David Rosenberg, who has been extremely bullish on the financial markets over the last three years, provided a very interesting chart in his recent daily commentary. To wit:

"Looking back through the historic economic expansions in the U.S. that were at least as long as the current one (so looking at the cycles that began in July 1938, March 1961, December 1982, Appril 1991 and December 2001), something somewhat notable popped up: if we look at relative performance of the equity market at this point, the S&P 500 has increased by 14% more than the previous max for this point of the expansion (which was the cycle that began in April 1991) and is up by 48% relative to the average of where these previous five cycles were at this point. This comes despite the historically lackluster economic recovery."

"Similarly, looking at the trailing P/E ratio suggests that the S&P 500 is at a comparatively rich valuation currently relative to these previous long-duration expansions."

Despite the fact that these measures should clearly suggest some caution, Rosie throws caution to the wind by suggesting that these extremes don't matter "this time" because of the Earnings Yield to Treasury Yield model, more commonly known as the "Fed Model", deflates those extremes. (Read more on the Fed Model here)

The problem with the Fed Model is two-fold. First earnings yield has been fabricated to a large degree by massive share repurchases and accounting gimmickry despite weak revenue growth as shown in the chart below.

Secondly, Treasury yields have been smashed due to the artificial interventions of the Federal Reserve.

Lastly, the whole premise is faulted from the basic fact that while investors receive the yield from owning Treasury bonds they do NOT receive the earnings yield.

It is during the next reversion process to normalization that investors will remember"price is what you pay, value is what you get." Historically, when that has been forgotten, outcomes have been extremely poor.

Doug Short - Four Bad Bears

My friend and colleague, Doug Short, regularly updates a series of charts entitled "The Four Totally Bad Bear Recoveries" which cover the crashes and recoveries of 1929, 1973, 2000 and 2007.

In his latest update, Bob Bronson of Bronson Capital Markets Research notated Doug's most recent chart as follows noting:

"I also would like to point out something most of your readers won't notice in this very illustrative eight-year (2,000 trading day) chart. Notice that all four were down roughly 40% during the first 1.5 years (~ 374 trading days) as high-lighted in the center of the black oval that I've annotated. Then three of them zigzagged roughly sideways for the next 6.5 years as indicated by my horizontal black arrow.

If the current index declines about 50% from its Feb 25 real total return high, as shown by the blue dashed arrow, it will be about in the center of the cluster on ~Oct 11th of this year — the end of your well-chosen 2,000 trading day range.

You might call this a normalized expectation, or at least reversion to the mean."

The reason I point this out is because this drives to the heart of the point that I was making recently in regards to 2009 being the beginning of the next great secular bull market.

"While stock prices can certainly be driven much higher through global Central Bank interventions, the inability for the economic variables to "replay the tape" of the 80's and 90's increases the potential of a rather nasty mean reversion in the future. However, it is precisely such a reversion that will create the "set up"necessary to start the next great secular bull market.  But as was seen at the bottom of the markets in 1942 and 1974, there were few individual investors left to enjoy the beginning of that ride."

If we assume that Bob's analysis is correct, given the historical tendencies of mean reversions, then valuations would fall, assuming earnings remain constant, to roughly 10x earnings. This would bring market valuations, as shown below, to levels that have more historically associated with the beginning of "long-term secular bull markets."

"Secular bull" and "secular bear" markets are a function the alignment of the economy and markets over time. Since the market is a market of "companies" and those companies are a reflection of real economic activity, extreme deviations from reality must eventually be realigned. Those realignment processes are what have led to the creation of long-term secular markets.