Where are we in the secular (post-2000) bear?

Mish Shedlock’s investment management company, Sitka Pacific, provided this chart in their September letter (as a non-client, I only get delayed copies):

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One lesson to be learned here, which they get into in the letter, is that prices bottom before valuation multiples. In the bears of the 1910s, ’29-early 40s and ’66-82, inflation appeared late in the game. BTW, this meshes with Kondratieff theory, where inflation leads to disinflation to deflation then inflation again, with asset values moving in tandem.

So, be prepared to buy in this coming wave down, if we get a nice drop over the next year or so, because select equities could be a nice hard asset to own through the turmoil in the currency and sovereign debt markets, which is likely to spread to the US, UK, Germany and Japan by later this decade.

Not much between here and Dow 8500

Many of the world’s stock markets have already retraced large portions of the entire rally from the 2009 lows, but US equities have a long way to go before they give traders a scare. Judging from the sanguine attitudes expressed by various managers on Bloomberg TV, the majority remains firmly convinced that the lows are in and that any sell-off is just a healthy correction on the way to new all-time highs. This is exactly the same attitude expressed from late 2007 to mid-2008 before the crash got underway in force.

Stockcharts.com

Since we are still in the early phase of the credit deflation and most people remain unconvinced of its magnitude and implications, this next decline in asset prices could be very swift and deep, driven by the panic of recognition. Technical support has already been taken out, and dip buyers will be less eager, since they have seen that stocks can indeed crash. We could see an unrelenting slide like the two years from April 1930 to July 1932.

There won’t be another bounce of the magnitude we’ve just seen until real value is restored by attractive dividend yields. A 7% yield on today’s dividends would put the S&P 500 at 350 or the Dow under 4000, but this assumes dividends won’t be cut and that the recent years of extreme overvaluation won’t be matched by an era of extremely low valuations as the culture of financial speculation dies off.

Taleb video: credit crunch not black swan, moral hazard now worse

From Bloomberg:

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Some great comments on the OMB (“lying on their forecasts”), Geithner (“who has a mortage on a house not far from mine… who didn’t understand risk and real estate prices”), Summers (“uses wrong mathematics in his papers” and has “systemic arrogance”), and Bernanke (“the one who crashed the plane”).

He has praise for David Cameron, whom he thinks understands how to solve the crisis.

Plenty of fodder for inflationists and bond bears here: Hard assets like metals and agricultural land would be a good way to protect value. Forget the stock market and most real estate.

Does anybody, such as professors, now understand the issues he raises? No. Don’t go to business school, but if you go, don’t take any business class that has equations in it: “it’s all bogus.”

Econ prof: Was there really a housing bubble?

Just when you thought your respect for economics PhDs couldn’t get any lower,  a professor at the top-ranked University of Chicago, Casey Mulligan, is making the case in the New York Times that there was no bubble in housing:

Adjusted for inflation, residential property values were still higher at the end of 2009 than 10 years ago.  This fact raises the possibility that at least part of the housing boom was an efficient response to market fundamentals.

Inflation-adjusted housing prices and housing construction boomed from 2000 to 2006 and crashed thereafter.  Commentators ranging fromPresident Obama to Federal Reserve Chairman Ben S. Bernanke have described that cycle as a “bubble,” by which they mean that, at least in hindsight, the housing price boom was divorced from market fundamentals.

But maybe there was a good, rational reason for housing prices to increase over the last decade.

Let’s consider first what it means to believe that the spike in prices since the late 1990s was unwarranted — the so-called “bubble theory.”

According to the bubble theory, for a while the market was overcome with exuberance, meaning that people were paying much more for housing than changes in incomes, demographics, technology and other basic factors would suggest.

Now that the bubble is behind us, people today should be no more willing to pay to own a house than they were in the late 1990s. (It’s true that population has grown since the 1990s, but population growth is nothing new and should not by itself increase real housing prices.  Don’t forget that greater population also means more people available to do construction work.)

Yet, the professor points out, house prices are still well above 1990s levels:

Ok, so his basic point is that because housing prices haven’t yet declined to 1990s levels, there was no bubble. He doesn’t consider the obvious alternative: maybe prices don’t move in straight lines and that the sideways action in 2009 was the result of an $8000 tax credit and general upswing in market optimism (as seen in stocks and commodities).

Maybe, just maybe, as in Japan after 1989 and the US after 1929, housing prices will decline in a herky-jerky fashion for many years after the peak.

Mama, don’t let your babies grow up to be economists. They’ll never stay smart and they’re always confused.

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In other bizarre housing news via patrick.net, some real California estate foreclosure prevention scammers were tied up and tortured after they ripped off another team of real estate rip-off artists.

Manufacturers: 70% of jobs lost are not coming back.

This via Dave Rosenberg (free sign-up required):

BLEAK JOB MARKET OUTLOOK

We said before that what really stood out in this “Great Recession” was the permanency of the job decay. Of the eight million jobs lost, three-quarters were in positions that are not likely coming back.

We just heard from the National Association of Manufacturers that fewer than 30% of the manufacturing jobs lost in the sector will be recouped in the next six years. So here’s a bit of math: if this holds true for the economy as a whole, and assuming a normal cyclical upturn in the labour force participation rate, then the nationwide unemployment rate would be 15% in six years’ time. How anyone can believe that we can squeeze inflation out of that scenario is truly one of life’s many mysteries.

We have to let Kondratieff winter play out and do its job of debt liquidation before the long-term employment cycle can start up again. With extend-and-pretend and mark-to-fantasy, this is going to be a long process.

Long Wave Analyst

As for manufacturing jobs, good luck with that. The US educational system pretty much seals the fate of anything engineering rated — my advice there is keep your kids out of those unionized prisons. Better to pool resources with friends and hire tutors and (Chinese-speaking) nannies. I wonder, how many government teachers can an iPad replace?

Take this week’s equity drop seriously.

Longs are playing with fire here. This market is at least as dangerous as 2007 or 2000. What happens when this multi-decadal asset mania fizzles out, like they all do? The last 12 months show that it won’t give up the ghost without a fight, but it is very long in the tooth, as is this huge rally. Also, the short-term action of smooth rallies followed by sudden drops is uncannily similar to 2007.

Stocks left the atmosphere in 1995, but since 2000 gravity has been re-asserting itself. After extreme overvaluation comes extreme undervaluation. On today’s earnings and dividends, even average or “fair” multiples would put the Dow near 4000, right back to 1995.

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Charts from Stockcharts.com

A note on gold and the dollar:

I suspected a few weeks ago that gold had a rally coming, and now that we’ve seen it I’d be careful to use stops and not get too confident.

I still like gold for preservation of purchasing power through this secular bear market in real estate and stocks, but when financial markets turn down again in earnest it won’t be spared. Remember, it kept going to new highs in late 2007 and early 2008 after stocks had peaked, but then tanked with everything else when panic hit. Cash is still king, especially in US dollars and Treasury bonds. We may have only seen the start of this deflation.

Analysts and institutions: stocks “extremely cheap” despite 1.7% yields after 80% rally. Hussman & Prechter: another crash likely.

Bloomberg today gives a tour of the bull camp, which believes in a V-shaped recovery and soon-to-be record S&P earnings:

Even after the biggest rally since the 1930s, U.S. stocks remain the cheapest in two decades as the economy improves…

…Income is beating analysts’ estimates by 22 percent in the first quarter, making investors even more bullish that the rally will continue after the index climbed 80 percent since March 2009. While bears say the economy’s recovery is too weak for earnings to keep up the momentum, Fisher Investments and BlackRock Inc. are snapping up companies whose results are most tied to economic expansion.

“The stock market is incredibly inexpensive,” said Kevin Rendino, who manages $11 billion in Plainsboro, New Jersey, for BlackRock, the world’s largest asset manager. “I don’t know how the bears can argue against how well corporations are doing.”

S&P 500 companies may earn $85.96 a share in the next year, according to data from equity analysts compiled by Bloomberg. That compares with the index’s record combined profits of $89.93 a share from the prior 12 months in September 2007, when the S&P 500 was 19 percent higher than today.

Those figures would be for operating earnings, not the bottom line. In recent years it has been increasingly common to simply call operating earnings “earnings” and to imply that multiples on this figure should be compared to historic multiples on the bottom line. Ken Fisher, readers may recall, was running obnoxious video web ads through 2007-2008 touting a continued rally just before stocks fell off a cliff. His equity management firm makes the most money if people are all-in, all the time, as it collects fees as a percent of assets.

Record Pace

The earnings upgrades come as income beats Wall Street estimates at the fastest rate ever for the third time in four quarters. More than 80 percent of the 173 companies in the S&P 500 that reported results have topped estimates, compared with 79.5 percent in the third quarter and 72.3 percent in the three- month period before that, Bloomberg data show.

It is impressive how companies have protected themselves since the downturn began, but the way they have done this is by simply cutting costs, hence the stubborn 9.5% (headline U-3) or 17% (U-6) unemployment rate.

David Rosenberg, as usual, is the cooler head in the room:

Alternate Valuation

David Rosenberg, chief economist of Gluskin Sheff & Associates Inc., says U.S. stocks are poised for losses because they’ve become too expensive. The S&P 500 is valued at 22.1 times annual earnings from the past 10 years, according to inflation-adjusted data since 1871 tracked by Yale University Professor Robert Shiller.

Economic growth will slow and stocks retreat as governments around the world reduce spending after supporting their economies through the worst recession since the 1930s, said Komal Sri-Kumar, who helps manage more than $100 billion as chief global strategist at TCW Group Inc. The U.S. budget shortfall may reach $1.6 trillion in the fiscal year ending Sept. 30, according to figures from the Washington-based Treasury Department.

“The correction is going to come,” Sri-Kumar said in an interview with Bloomberg Television in New York on April 21. “You now have a debt bubble growing in the sovereign side, and we’re slow to recognize how negative that could be.”

We are still in the thick of the largest credit bubble in history. Consumer and real estate debt has yet to be fully liquidated (and hasn’t even started in China), corporate indebtedness is the highest ever, and now government debt has reached the point of no return where default is inevitable.

Equity is the slice of the pie left over after all debts are serviced, so to say that it is cheap when it only yields 1.7% (in the case of S&P dividends) is insane. It is much safer to be a creditor of a business than an owner, so debt yields should be lower than equity yields. In today’s perverse investment climate, even 10-year treasuries of the US and Germany yield more than twice equities.

This extreme confidence in stocks and dismissal of risk considerations further indicates that this is a toppy environment, highly reminiscent of 2007.

John Hussman explores this theme a bit further in his latest market comment:

As of last week, our most comprehensive measure of market valuation reached a price-to-normalized earnings multiple of 19.1, exceeding the peaks of August 1987 (18.6) and December 1973 (18.3). Outside of the valuations achieved during the late 1990′s bubble and the approach to the 2007 market peak, the only other historical observation exceeding the current level of valuation was the extreme of 20.1 reached just prior to the 1929 crash. The corollary to this level of rich valuation is that our projection for 10-year total returns for the S&P 500 is now just 5.3% annually.

While a number of simple measures of valuation have also been useful over the years, even metrics such as price-to-peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were about 50% above the historical norm – reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity-oriented industries. Accordingly, using price-to-peak requires the additional assumption that the profit margins observed in 2007 will be sustained indefinitely. Our more comprehensive measures do not require such assumptions, and reflect both direct estimates of normalized earnings, and compound estimates derived from revenues, profit margins, book values, and return-on-equity.

That said, valuations have never been useful as an indicator of near-term market fluctuations – a shortcoming that has been amplified since the late 1990′s. The lesson that valuations are important to long-term investment outcomes is underscored by the fact that the S&P 500 has lagged Treasury bills over the past 13 years, including dividends. Yet the fact that these 13 years have included three successive approaches (2000, 2007, and today) to valuation peaks – at the very extremes of historical experience – is evidence that investors don’t appreciate the link between valuation and subsequent returns. So they will predictably experience steep losses and mediocre returns yet again. Ironically, before they do, it also means that investors who take valuations seriously (including us) can expect temporary periods of frustration.

I’ve long noted that the analysis of market action can help to overcome some of this frustration, as stocks have often provided good returns despite rich valuations so long as market internals were strong, and the environment was not yet characterized by a syndrome of overvalued, overbought, overbullish, and rising yield conditions. In hindsight, the stock market has followed this typical post-war pattern, and we clearly could have captured some portion of the market’s gains over the past year had I ignored the risk of a second wave of credit strains (which I remain concerned about, primarily over the coming months).

It is important to recognize, however, that even if we had approached the recent economic environment as a typical, run-of-the-mill postwar downturn, we would now be defensive again, as a result of the current overvalued, overbought, overbullish, rising yields syndrome. I do recognize that my credibility in sounding a cautious note would presently be stronger if I had ignored further credit risks and captured some of the past year’s gains. But the awful outcome of this same set of conditions, which we also observed in 2007, should provide enough credibility.

Hussman proceeds to offer a detailed statistical analysis of how valuation and market action impact risks and returns. Curious parties are encouraged to read his essay in its entirety.

Here is how he rather bluntly sums up the current environment:

As of last week, the Market Climate in stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically produced periods of marginal new highs, slight declines, and yet further marginal highs, followed somewhat unpredictably by nearly vertical drops. I’ve often accompanied the description of this syndrome with the word “excruciating,” because the apparent resiliency of the market and the celebration of each fresh high, can make it difficult to maintain a defensive stance. Interestingly, the analysts at Nautilus Capital recently noted that the most closely correlated periods in market history to this one were the advances of 1929 and 2007. While exact replication of those advances would allow for a couple more weeks of further strength, we’ve generally found it dangerous to expect history to do more than rhyme. These hostile syndromes have a tendency to erase weeks of upside progress in a few days.

I have to agree with this assessment as well as that of Robert Prechter that this spring offers perhaps the greatest short-selling opportunity in history.

Extreme optimism and extremely low dividend yields

The 20-day average equity put:call ratio has dived to new lows, and yesterday the single-day reading printed 0.32, among the eight lowest readings since 2004.

Indexindicators.com

From stockcharts.com, here’s the raw data going back to 2004, plotted against SPX:

It looks like the closest previous instance of such a string of super-low readings (though not as many as at present) was Dec 2003 – Jan 2004, which marked the middle of the final lunge before an eight-month correction of the bull trend. Of course, that was during the fastest period of mortgage and consumer debt accumulation the US has ever seen, whereas today we are still unwinding that mess.

The markets certainly think this is 2004 and that earnings are going to explode back to the peak levels of 2007, even though it took an orgy of debt to generate those for just a few short quarters. Dividend-wise, stocks are yielding half as much as the 10-year bond, which is guaranteed to deliver those coupons, while common shareholders just hold a derivative claim.

From multpl.com, here’s the dividend yield on the SPX (and theoretical predecessor) going back to 1881 (top) vs the inflation-adjusted price (bottom). Even at the lows last year, stocks were never even close to a good deal in historical terms, and in fact their yield then was about the same as at the 1898, 1907, 1929, 1966, 1968 and 1987 market peaks:

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It’s clear from these charts that investing in a low-yielding market is not a winning strategy for capital preservation.

Market overvalued even if you accept very optimistic forecasts.

These charts and analysis come from Bill Hester at Hussman Funds. Hester and John Hussman do the best fundamental analysis of anyone I follow. It was Hussman’s writing, more than anything else, that first convinced me of the bear case back in 2006.

Except in relation to bubble valuations between 1997 and 2007 (which have produced flat or negative market returns), the market’s valuation looks overpriced based on widely-tracked fundamentals. Whether you look at price-to-normalized earnings, price-to-dividend multiples, price-to-book values, or price-to-sales multiples, they all sit above their long-term averages. The graph below shows the price to sales ratio for the S&P 500 since the early 1960′s. The current price-to-sales ratio of 1.28 percent is far above its long-term average (outside of the bubble valuations of 1997-2007) of about .83. Prior to the late 1990′s, major market peaks such as 1972 and 1987 were typically marked by a price/sales multiple not much above 1.0.

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Since traditional measures of valuation are broadly overvalued, analysts who are recommending additional equity exposure tend to use P/E ratios based on future estimates for operating earnings. On that measure stocks are still overvalued, but less so. But the current forward operating earnings may be overly optimistic once you back out the assumptions they rely on. More modest assumptions would suggest that the market is overvalued even on forecasted fundamentals.

Analysts forecast that the S&P 500 companies will $78 by the end of this year, $93 through next year, and $106 through 2012, based on analyst estimates tracked by Bloomberg. That’s an expected jump of 25 percent this year, 20 percent next year, and another 14 percent the following year. Clearly, stock analysts aren’t buying the New Normal…

the aggressive expectations in forecasted earnings growth rates rest not only in corporate performance detaching from the economic climate, but also from corporate fundamentals veering far from their long-term typical performance. The clearest example of this is in the expectations for profit margins.

While earnings growth expectations are steep, sales growth expectations are more modest. Sales-per-share for S&P 500 companies is expected to grow about 5.5 percent this year and about 7 percent next year, according to forecasts. The difference between the growth rates of the top and bottom lines is implies a forecast for sharply rising operating profit margins. The graph below is updated from an earlier piece, and includes forecasts through the end of 2012. It plots the long-term level of S&P operating margins in blue. In red, I’ve plotted the operating margins currently being forecasted by analysts based on their projections for sales and earnings. Last October, analysts were about half way to pricing in profit margins that matched the record levels of 2007. Now, they are just about there.

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These forecasted operating margins are important to investors who rely on using a P/E multiple based on forward earnings. Even with these forecasts for near-record profit margins, valuations on forward operating earnings are not favorable. The current multiple is about 14.8. As John Hussman has noted , the long-term average P/E ratio based on forward operating earnings is about 12. Taking the 14.8 multiple at face value implicitly assumes that the near-record profit margins assumed by analysts are now the long-term norm. Even a minor lowering of expected profit margins would cause the scale of the overvaluation to widen materially. Considering the aggressive expectations for profit margins, the market’s valuation based on expected results may be as stretched as it is on trailing fundamentals.

I recommend reading Mr. Hester’s analysis in full here, as well as John Hussman’s weekly market comments.