From Generational Bottom to Cyclical Top?

 | Mar 31, 2014 | 1:30 PM EDT  | Comments
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"I've been a bear for three years," said Mr. Kass, general partner of Seabreeze Partners Management in Palm Beach, Fla. "This is a big change for me."

Mr. Kass said the March lows would not just represent the lowest points of the year, but "possibly a generational low."

Last week, he wrote a note, "Why the Bears Are Wrong," that tallied a host of hopeful conditions in the economy and the financial system.

He saw potential in the Obama administration's plan to buy $500 billion to $1 trillion in troubled assets from banks using a blend of public and private money. If it works, the move could take the strain off the banks' struggling balance sheets and loosen credit markets, Mr. Kass said.

Many analysts have said that financial companies, which plunged the markets into crisis, will be the ones to lead the way to higher ground, and Mr. Kass said he was cheered to see big banks leading the March rally. The S.& P. Financials Index rose 33 percent from March 9 through Monday, while the broader S&P 500 gained 16 percent.

Commodity prices for metals and oil began to rise, signaling a hint of inflation and a chance that economic growth could find a foothold, he said. And he said he was encouraged by a bouquet of better-than-expected reports from the housing and retail sectors.

Given the speed of the rally, however, Mr. Kass wrote a note on Friday saying that investors might seize the opportunity to raise cash and take profits. But he said he was still convinced that "the U.S. stock market will rise to levels higher than most anticipate," by as much as 25 percent by summer.

Mr. Kass said he liked companies like Home Depot, Lowe's, the Walt Disney Company and real estate investment trusts.

Even optimistic investors warn that a recovery in stocks will not look like a steady climb, and they say that economic growth may be slow for some time. But as stocks have picked back up, Mr. Kass said, he has noticed a new concern among investors.

"The fear of being out has begun to replace the fear of being in," he said.

-- Jack Healy, "A Pitched Battle for Turf Between the Bears and the Bulls," The New York Times (March 30, 2009)

"There are definitely speculative excesses in the market right now," said Doug Kass, president of Seabreeze Partners Management. "I don't think the whole market is in a bubble. But in biotech and some of the Internet stocks, there's no question -- we've certainly got bubblelike symptoms. And the I.P.O. market looks like a bubble, and that's serious, because that's where the first signs of the bear market that started in 2000 began."

-- Jeff Sommer, "In Some Ways, It's Looking Like 1999 in the Stock Market," The New York Times (March 29, 2014)

What a difference five years make.

Back in March 2009, I opined on "The Kudlow Report" that a generational bottom was being made during the first week of that month.

Five years later we stand nearly 200% higher in the S&P 500.

As illustrated in the chart below, Warren Buffett's favorite valuation measure -- namely, market capitalization as a percentage of nominal GDP -- has risen in the last five years from approximately 70% to over 140% today.

One of the great technical analysts (now retired) in modern stock market history sent me an email over the weekend and referenced the warning that this ratio is communicating:

There is no magic level for this relationship because what is extreme has changed over the years, particularly since the late 1990s. From the mid-1920s to the end of the 20th century, low undervalued levels were in the 20%-30% range and high levels were 70%-80% (1929 even went to 88%). Since 1998, however, the relationship of stock capitalization to GDP has changed. The huge increase in share issuance and valuations that accompanied the information technology boom in 2000 took the extreme to 174% or almost twice the previous peak made in 1929. Since then there was a low of 92% in 2002, a high of 140% in 2007 and a low of 70% in 2008. Now, five years later the ratio is back up to 144% as of mid-March 2014. We know it could go higher but presuming we have a new range since 2000 and the extreme in that year (174%) is similar to the extreme in 1929 that was not reached for the next 70 years, we have to assume that any ratio extreme currently in the 140%-160% range is a seriously high potential peak overvaluation area. It is noteworthy, that even at a lesser extreme of 125% reached in 2011, a 21% market correction ensued. Or to put it another way, if the 1930-1998 danger signal was a ratio of 70% or over and the new post-2000 range is about double the prior 70 year range, then over 140% maybe the new normal for overvaluation. The current level of 144% should at least tell us to be on guard. Risk is in the air and maybe in portfolios as well.

Is History Rhyming?

Four successive years of strong first-quarter stock market returns has been broken this year. And the quarter has ended with a breakdown in previous high-octane, high-beta leadership and with the Russell 2000's relative performance waning. (Note: The same technical analyst mentioned earlier has taught me throughout the years that major market leadership changes often occur late in a bull market cycle.)

Meanwhile, a rotation into previously poorly performing conservative technology, telecom, big pharma, utilities and oil stocks (remember how badly these sectors performed in 1997-1999) remind this observer of the rotation back into value stocks in early 2000, right before the decimation of tech/Internet stocks began to occur.

Over the weekend I questioned, in Saturday's New York Times business section, whether the undervalued conditions that existed five years ago have been reversed and whether the U.S. stock market is overvalued now.

Let's compare the Marches of 2009 and 2014.

In the past I have outlined how we can identify the characteristics of bubblelike conditions.

In the main I see three bubbles that exist today:

  1. the IPO market;
  2. the social media sector; and
  3. the belief that the Fed's quantitative-easing policy is sufficient by itself to generate a self-sustaining domestic economic recovery.

Away from identifying these three bubbles, most other asset classes (e.g., the U.S. stock and bond markets) have not entered bubblelike territory, but they are, arguably, entering levels of excessive speculation.

Comparing March 2009 to March 2014

There are several clear examples of why the markets of March 2009 and March 2014 are almost diametrically opposed, posing risks today just as they posed opportunities five years ago.

In valuation and investor sentiment today we seem to be at the polar opposite of 2009.

Earnings. As a generalization, I would say that the one mistake that the bears made in 2009 was to look at stated or nominal S&P earnings and to attach a P/E ratio to it in an attempt to determine where we are in the market cycle. Back five years ago at the bottom of the market, the S&P 12-month trailing earnings approximated $45 a share. At 666 on the S&P, the near-15x P/E ratio was nothing to write home about.

But back then I made the argument that rather than looking at stated corporate profits we should be looking at normalized profits -- that is, earnings power adjusted for a normalized economy. I was using normalized profits of about $70-$75 a share for the S&P 500 at that time, making the P/E at only about 9x exceptionally attractive.

Let's contrast that with today's estimated 2014 S&P profits of approximately $120 a share. I have argued and I continue to argue that nominal profits are overstating the health of corporations (just as the health was understated in 2009). Profit margins, in particular, at nearly 70% above the average over the past six decades and at the highest level since 1955 overstate normalized profitability.

So, are we making the same mistake in attaching P/E ratios to stated/nominal earning s today as we did back in 2009?

Investor sentiment. On the issue of speculation, there is little question that there are now pockets of speculative excesses in the IPO market, biotech and elsewhere (e.g. social media and in certain disruptors such as Tesla (TSLA)).

There is also little question that we are in a bubble in the belief that the Fed and monetary policy can by itself lead to a self-sustaining domestic economic expansion.

But it is the area of investor sentiment in which we seem to be at opposites.

In 2009, hedge funds were at their lowest net long exposures in several years. Investor sentiment, as expressed in AAII and Investors Intelligence, was similarly distraught.

Consider the comments in the March 2009 New York Times column, in which I debated legendary (and then bearish investor) Robert Rodriguez at First Pacific Advisors (who embraced the negativity of the period). His concerns were illustrative of the bearish meme back then:

What optimists do not understand, says Mr. Rodriguez, chief executive of First Pacific Advisors, is that the United States is being profoundly reshaped by this recession.

"We've crossed over into a new financial era," he said. "You don't know what the ground rules are. You don't even know what the shape of the playing field is."

Economic growth may be stagnant for years, even after the economy hits bottom. Corporate profits may not bounce back. And the high hopes for recovery that have helped drive stocks higher this month may yet crumble.

Stock markets rose 10 percent or more several times during the Depression, the early 1970s and other downturns, only to lose their momentum and give back months of gains. As bearish experts warn, market bottoms come only when investors give up hope of ever seeing a bottom.

"This rally that's going on may prove ephemeral," Mr. Rodriguez said. "I still think we have a very long, arduous journey ahead of us...."

"The stock market will be very volatile, and corporate profitability will be very volatile," Mr. Rodriguez said. "There are large segments of the United States economy that will never come back."

-- Jack Healy, "A Pitched Battle for Turf Between the Bears and the Bulls," The New York Times (March 30, 2009)

The Bottom Line

I continue to hold to the view that the S&P 500 is fairly valued at approximately 1650 (or about 10% below current levels) and that the expected range in the S&P for the balance of the year should be between 1700 and 1925. With the S&P now at 1850, the risk (150 S&P points) exceeds the reward (75 S&P points) by a factor of 2 to 1.

While I expect equities to be down by 5% to 15% in 2014, I am uncertain as to the timing of a potential downturn.

At best I view 2014 as a year of subpar returns.

At worst, a cyclical bear could lie around the corner.

For now I am positioned market-neutral, and I prefer being reactionary (rather than anticipatory), looking for Mr. Market's price action to give me some direction.

The major market risks include a downgrade in valuations (and P/E ratios), disappointing corporate profits (and profit margins), less vigorous global economic growth (which might be the message of the recent flattening in the yield curve) and the likely emergence of natural price discovery in the capital markets as the Fed begins to taper and ultimately raise interest rates.

The first quarter of 2014 is the first opening three-month period of a year since 2009 that the market has made no progress.

Market leadership is changing, often a worrisome signal.

Previously poorly performing large-cap conservative market sectors are strengthening just as the market leaders have slumped, which is reminiscent of the weakness in large-cap value in 1997-1999 and the firming up in early 2000 right before the market's schmeissing.

The upcoming reporting period might prove to be a market catalyst to the downside.

In terms of comparing the Marches (2009 and 2014), obviously generational bottoms occur only once a generation, but cyclical tops (and bottoms) are entirely other things -- they happen with frequency.

I conclude that stocks, which with the benefit of hindsight were at the generational bottom five years ago, might very well be mapping out a cyclical top in early 2014.

History doesn't repeat itself, but it sure as hell rhymes.


This column originally appeared on Real Money Pro at 9:13 a.m. EDT on March 31.

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