This commentary originally appeared at 8:48 a.m. EDT on April 15 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
"The Zen philosopher Basho once wrote, 'A flute with no holes is not a flute. And a doughnut with no hole is a danish.'"
-- Ty Webb (Chevy Chase), Caddyshack
In looking back, the biggest surprise to me through the first three months of the year is that P/E multiples have expanded despite unprecedented secular economic and employment challenges, with growing evidence that the global economic outlook is eroding and that the bullish consensus estimates for S&P 500 profits is in jeopardy.
Faith, Low Interest Rates and Liquidity Have Buoyed Markets
So far in 2013, the U.S. stock market has risen based on extraordinary doses of liquidity injections and growing confidence that global easing will trickle down, improving overall confidence, lifting jobs growth, buoying the world's economies and propelling corporate profits to new records.
There Is No Free Lunch
It remains my view, however, that there is no free lunch associated with the grand experiment of almost unlimited quantitative easing. It is as if the central bankers are trying to repeal the laws of investment gravity, as countries and regions of the world make a mad dash to debase their currencies in an attempt to spur export growth.
Monetary policy is camouflaging the underlying weakness in worldwide economic growth and is contributing to an artificiality in today's elevated stock and bond prices. Indeed, virtually all economic indicators point to weakness in March, as the fiscal drag (higher taxes, lower government spending and the distortion in traditional corporate hiring practices, owing to the implementation of the Affordable Care Act) that I have often written about has begun to show up.
I use the Caddyshack epigraph as a metaphor for the increased ineffectiveness and reduced influence of quantitative easing on our domestic economic activity.
Continued massive monetary easing in the U.S. has lost much of its overall marginal impact -- there is still little credit growth. With "QE Infinity" no longer producing a tangible influence on the real economy, more easing is much like a flute without holes that cannot be played or a doughnut without holes (not being a doughnut but rather a danish).
While many are certain that continued liquidity will feed a steady market climb into 2014, sooner than later, there will likely be an "aha moment," a moment in time when the aggressive monetary policies are recognized as not only impotent and ineffective but as likely having adverse unintended consequences (such as producing currency wars). At that point in time, natural price discovery will be reintroduced into the capital markets, and stocks and bonds will retreat back closer to intrinsic or fair market values, which I view as well below current levels.
For those who believe that the U.S. stock market feels like it will never decline (and that global easing is the panacea for growth and will produce ever-rising share prices), I 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. Gold futures have dropped by almost 10% since last Thursday's close, following a lengthy decline that had already occurred, and Apple's shares now stand at near $425 a share compared to $700 a share just six months ago.
Holders of gold (or gold-mining shares) and/or Apple shares feel far different today than when the commodity or shares were embraced in an extreme sentiment pull toward inappropriate valuations months ago.
The only thing I remain certain of is the lack of certainty and that some of the emerging fundamental and technical conditions are consistent with classic top signs over stock market history.
Global Growth Is Slowing, and a U.S. Recession Is Possible
Instead of producing an acceleration in economic growth in the U.S. and elsewhere, it is my view that global growth is now starting to slow to a rate that jeopardizes the bullish consensus on corporate profits.
In the U.S., it can now be argued that the marginal impact of more monetary stimulation is not only having a limited impact but that it may be beginning to even have a negative effect on growth in the real economy by robbing interest income from the savings class.
I maintain an out-of-consensus view that a recession in the U.S.by 2014 holds about a 50% probability.
Meanwhile the outlook for the European economies deteriorates almost daily. This is particularly true for the southern countries in the eurozone that appear to be in an economic death spiral. The most recent economic data out of France has been much worse than generally forecast, and, not surprisingly, Germany appears to be catching a bad economic cold.
Last night, following weaker-than-expected economic data from the U.S. and eurozone, China's GDP economic data and industrial production release failed to meet expectations, serving to reinforce the notion that the pace of global economic activity is moderating. But even before yesterday's data, China's rosy economic outlook could be disputed as the on-the-ground data are generally inconsistent with the public healthy growth releases.
The Line Between Progress and Reality Is Blurred
The gap between the rising U.S. stock market and the visible deceleration in the rate of global economic growth has been widening in a more dramatic and conspicuous fashion over the past several weeks, and my cautious market view is growing more bearish.
The weakness in the most recent U.S. March ISM release, the fall in consumer and small business confidence, disappointing March retail sales, a sharp drop in the Citigroup U.S. Surprise Index, worsening EU economies and/or any of a number of other factors affirm that global growth is slowing to a rate that will likely imperil the ambitious consensus for corporate profits. Other recent endorsements of the slowing global growth thesis include (most notably) the intensification in the drop in commodity prices (copper and gold, in particular). Also:
- U.S. Treasury yields are falling;
- the yield curve is flattening;
- the high-yield credit market is no longer rallying;
- the economically sensitive transportation index is faltering;
- there has been a near-record percentage in the number of companies issuing earnings warnings;
- the U.S. stock market leadership is focused on defensive high-quality consumer staple stocks (paying relatively high dividends) as opposed to aggressive, high-beta stocks; and
- with the exception of the U.S. and Japan, many markets around the world are struggling.
All of the above conditions are indicative of moderating worldwide economic growth and have historically been associated with market tops -- or, at the very least, a more hostile environment for stocks.
Consensus Corporate Profits Expectations Are Overly Optimistic
If we distill my multiple concerns into one concern, it is the more difficult earnings backdrop that should become increasingly apparent to market participants in the near term.
Given that the growth in nominal U.S. GDP is trending at under 4%, corporations have little in the way of pricing power. And with profit margins at all-time highs and nearly 70% above the mean levels achieved in the last seven decades, earnings forecasts are threatened based on slowing top-line growth and a likely mean reversion in margins.
Though early in the reporting period, a chill in early first-quarter earnings is already visible (across many industries). Fastenal (FAST), FedEx (FDX), J.B. Hunt Transport Services (JBHT), Harris Corporation (HRS) and many leading technology companies have missed consensus forecasts and/or lowered forward guidance -- even during a first quarter in which the U.S. will likely exhibit +3% real GDP.
I remain fearful of what will happen to earnings when the rate of real growth in the domestic economy halves to around +1.5% over the last three quarters of the year.
An Extreme Short-Term Overbought
Up to now there is little question that investors are feeling the pressure of underperformance, chasing price strength and ignoring the warning signs of slowing global economic growth, a worsening profit outlook and expanding technical divergences (and low NYSE volume). Hedge funds are now at their highest net long exposure in some time, sentiment studies are uniformly bullish, and retail investors are warming up to stocks. As a result of these factors (and others), stocks are overbought -- maybe even dramatically so.
But I see it as only a matter of time until reality adversely impacts stocks. In fact, it is my view that this could happen momentarily.
The Bottom Line
It is for the reasons above (and others) that I am short of the market.