This commentary originally appeared at 8:40 a.m. EST on Feb. 19 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
This morning's opening missive is an expression of market opinion based on a compilation my most recent observations.
I like to produce this "Where I Stand" column at least on a monthly basis as a means of summarizing and keeping subscribers up to date with my investment outlook.
I continue to hold to a contrarian and bearish view of future worldwide economic growth and on the direction of U.S. corporate profits.
At the core of my concern is that a global economy built on a foundation of excessive monetary easing is one of low quality, decaying fundamentals and not likely to be effective or self-sustaining.
To me investors are not being realistic in their expectations (and almost magical thinking) that an aggressive printing press can relieve and trump the profound challenges and headwinds to global growth without any negative consequences.
I remain concerned that much of the current investor optimism expressed in a rising stock market is not consistent with the underlying economic and profit data.
Domestic economic growth is stumbling under the weight of structural headwinds, a continued deleveraging and the uncertainty of tax and regulatory policy.
I see little improvement ahead.
"In case you haven't seen a sales report these days, February month-to-date sales are a total disaster.... The worst start to a month I have seen in my seven years with the company."
-- Jerry Murray, Wal-Mart's (WMT) vice president of finance and logistics (in an email to Wal-Mart executives on Feb. 12, 2013)
Fourth-quarter 2012 U.S. real GDP contracted. Disappointing and subpar growth lies ahead, with the important consumer sector adversely impacted by tepid wage and salary income growth. Despite the props of a 5% year-over-year increase in home prices and a steady increase in stock prices, lower to middle income consumers are further suffering from:
- a jobs market that is not improving much;
- a 2% reduction in disposable income (due to the expiration of the payroll tax holiday);
- a marked reduction in refinancing activity (worrisome, as it occurred coincident with a modest mortgage rate rise);
- several months of consecutive gasoline price increases; and
- the specter of additional fiscal drag ahead (in March when the spending sequester will likely take effect).
While early indications are that domestic economic growth is improving from the dreadful fourth-quarter experience, the trajectory of growth is likely to be modest at best.
Nominal U.S. GDP growth is likely to expand by only 3% to 4% this year, an awful performance considering the unprecedented quantitative easing by the Fed. Even such sluggish growth requires the continuation of an excessively accommodative Fed (holding the risk of negative consequences), which makes our economy vulnerable to any exogenous shocks and still does not provide a suitable backdrop for healthy corporate profit growth.
Outside of the U.S., economic progress remains mixed. Activity in both Japan and the eurozone fell more than was generally expected, and China's economy is behaving marginally better than consensus expectations.
Today, despite analysts and strategists unrealistic optimism, participants' confidence in the markets is elevated as investors have cared little about slowing growth. I believe that reality will prevail, however, as ultimately corporate profits are the mother's milk of the markets.
Not only were fourth-quarter 2012 S&P profits and sales disappointing but forward guidance has been poor.
The current disconnect between stock prices and the slowing pace of earnings growth is reminiscent of the second half of 2007. The difference between then and now is 2007's emerging weakness was centered in the financial sector. By contrast, in late 2012 and expected in early 2013, the profit weakness is more broad-based.
At the start of the earnings season, the consensus forecast for fourth-quarter 2012 S&P 500 profits was about $25.50 a share -- now, with over 80% of the companies reporting, $23.50 a share looks more likely. (Missing fourth quarter 2012 by 8% is not a rounding error.)
A disappointing picture for S&P earnings lies at the core of my ursine market vision. In the fullness of time, an earnings cliff is not likely be ignored.
Consensus, top-down and bottom-up 2013 forecasts for the S&P 500 are at $108 a share, $107 a share and $112 a share, respectively, up from about $103 a share expected in 2012.
My projection is for $100 a share or less for S&P profits -- well below 2013 consensus and under the anticipated actual 2012 earnings.
Markets discount the future, not the past, and stocks today are arguably as expensive as they were in 2007 based on:
- the loss of business sales momentum;
- the risk of mean reversion in profit margins;
- how far operating profit forecasts have fallen in the last few months; and
- that a projected hockey stick recovery in consensus profits is unlikely.
It is my expectation that projections for domestic economic growth will decline further in the months ahead, led by weakness in the consumer sector (previously discussed). This will further pressure corporate profits.
Already supportive of my slowdown thesis is the recent flattening of the yield curve, a lower absolute yield on the 10-year U.S. note (down by about 8 basis points in the last few weeks) and a recent rollover in several credit risk metrics (including deterioration in the high-yield debt markets).
It remains my view that the 2013 real GDP in the U.S. will be (at best) +1.5%. This compares to the Congressional Budget Office's recently issued a forecast of +1.4%. To me there appears to be accumulating downside risks to economic growth in the form of the fiscal drag of policy and given that quantitative easing is losing its effectiveness.
With inflation running low, sales and profits will be challenged. Business pricing power is limited, but costs are likely to trend higher (raw materials, interest rates, etc.). Meanwhile, productivity is starting to decline -- it was down -2% in the fourth quarter of 2012 -- and unit labor costs are rising. This spells a threat to today's unprecedented and high profit margins, which are not likely to be as stable (as many prognosticators expect) but are more likely to mean revert over the next two years.
Not only are fourth-quarter 2012 S&P profits disappointing but forward guidance is poor.
In January, about 56 companies in the S&P 500 issued first-quarter 2013 earnings guidance: 45 were negative, and 11 were positive. That rate of negative guidance (80%) is the worst since FactSet started to keep these numbers (in 2006) and above the previous high established in last year's third quarter (74%).
Against the above backdrop of economic/ profit storms and continuing/unattended budget deficits, the only solution being offered appears to be global money printing.
It is a near universally accepted truth that the world's stock markets will continue to perform well as long as the global easing continues. And for now, the only thing that seems to matter is a continuation of that expansionary monetary policy.
Dialing up free money masks the secular problems temporarily, and, if done dramatically, and for an extended period of time (as is now the case), the consequences can be negative and the ability to dial back down more problematic.
Market optimism has lifted hedge funds to their highest net long exposure in 18 months and has resulted in a reversal from outflows to inflows into domestic equity funds and in a massive swing into extremely bullish territory in nearly every market survey of sentiment (and in the market's volatility indices).
The disconnect between weak economic fundamentals, ebullient investor sentiment and elevated stock prices form an unhealthy and potentially toxic cocktail.
For those who are of the view that the U.S. stock market feels like it will never decline (and that global easing is the panacea for growth and ever rising share prices), we suggest you look at the price of gold in mid-September 2011 and/or the price of Apple's (AAPL) shares in late-September 2012. At those points in time, investor sentiment was at an extreme. Now look at the subsequent price drops following those heights and where those prices stand today.
It is important to remember that over market history, progress often cuts with a manic edge. There is little or no permanent truth in financial markets as financial ideas have their seasons. So it is, as in the later stages of bull markets there is often a blurring between progress and fantasy.
In Minding Mr. Market, Jim Grant (Grant's Interest Rate Observer) once wrote, "The country's most admired companies are frequently on their way to becoming the least admired investments." Jim's comments might also apply today to the market indices.
I am as bearish on stocks as I have been in some time.