Market Perspective for February 26, 2013
A few thoughts about the various asset classes:
Occasionally we hear the old saw, “It’s not a stock market, it’s a market of stocks”. This is designed to remind us that the market as a whole should have some correlation to the welfare of the companies that comprise it. I’ve thought a lot about that saying lately. In the last several months many (myself included) have argued that the stock market has room to run because liquidity conditions are very friendly. If that is the case then one should be able to see upside potential in many of the stocks that comprise the market. At these price levels, however, I just don’t. I’ve been analyzing the market on a professional basis for over 26 years. I know what overvaluation and undervaluation look like. In early 2009, I could go through the Value Line Investment Survey and find bargains galore in every issue. The only thing holding me back was how much of a discount should I pay for the risk that the Recession we were in would turn into full-fledged Depression? It was clear at that point that if things only stopped getting worse that practically every stock was a buy.
It is so much different today. It is hard to find any stocks that are cheap and do not have serious questions attached to them. Apple, for instance, looks to be a very cheap stock at 10.2 times trailing earnings, but there are questions about Apple’s ability to innovate in the absence of Steve Jobs. Apple’s depressed multiple is also one of the reasons why the market overall looks cheaper than it is. Value Line’s most recent survey put the market’s P/E at just over 16. It also projects the market’s 3-5 year appreciation potential at 45%. While that seems bullish, appreciation potential has only been lower twice in the past two decades; the late 1990s into 2000, and in middle 2007 into early 2008. This is not to say that the market is about to plunge because valuation is a terrible timing tool. My argument is that stocks are trading as an asset class – one that is more attractive than either bonds or commodities from both a value and a fundamental standpoint – and not on their individual merits. All the liquidity the Federal Reserve has created has to go somewhere. Gold and bonds had a nice liquidity run but it surely appears that those two asset classes have run out of steam. Stocks are now the main beneficiaries of Federal Reserve’s policy of Quantitative Easing (QE) but when the Fed begins to shut down the liquidity spigot (and it’s a “when’, not an “if”), stocks are going lower. We got a taste of that this past week when three Fed Governors made anti-QE comments. Bottom line: This is a good time to make sure your portfolios are not overly heavy on stocks, and lighten up where you need to. It is okay to ride a liquidity bubble as long as you understand that’s what you are doing and are able to handle the risk of it bursting.
The thesis for gold is that Quantitative Easing will eventually cause an increase in inflation as too much money chases too few goods. It has been recently pointed out that the act of creating money doesn’t necessary mean that it is then added to general circulation (which is why inflation hasn’t taken off so far). Gold bugs counter that the Fed can’t remove liquidity without causing recession and the Fed prefers inflation to recession. So ultimately the Fed is stuck and inflation is still inevitable. Last week’s news that the Fed has begun thinking of ways to end QE hit the gold market hard because that would mean the anticipated inflation spike would not happen in this economic cycle. It is not clear by any means that the Fed can actually pull off a gradual normalization of the credit markets, but certainly gold investors no longer have the assurance that time is on their side. Bottom line: Speculative money is coming out of gold right now so the asset class is going to be volatile. At best this is a well-needed correction that sets up a test of $2000 sometime in the future. In the worst case, the secular uptrend is over.
Just simply looking at the level of bond yields it is clear that bond prices do not have a great deal of appreciation potential today. Bonds may be vulnerable to a sentiment shift similar to what has been going on with gold, where investors feel the ground shifting and decide to get out while there are still profits to save. However, I don’t believe that is going to happen. First of all, the demise of bonds has been predicted since 2009. Bonds tend to be weakest in the first quarter of any year as economic expectations start off strong and tend to moderate by Spring. The other thing bonds (and by this I mean longer term Treasuries) have going for them is optionality. Jeff Gundlach (Doubleline) and Bill Gross (PIMCO) have both pointed this out recently. The argument is that if you want to protect an equity portfolio against economic weakness you can buy an equity put option, but that costs you money and the protection is for a limited time. Long term treasuries, on the other hand, will probably rise if stocks tank, pay you while you wait, and don’t need to be rolled over every few months. The optionality argument largely explains why high quality bonds trade at negative yields from time to time. Because there are so few securities whose prices rise when times get tough, those that do will always carry at least some optionality premium. Bottom line: The secular downtrend in yields is not necessarily over. Don’t give up on treasuries just to catch a little more yield on the corporate side. If we slide back toward recession, Treasuries will help you. Corporate bonds will not.
Two of our favorite authors from GMO, James Montier and Jeremy Grantham, recently published two thought provoking pieces. Each article is available at www.gmo.com. You need to register for access but it’s well worth your time.
James Montier discusses how printing money, in and of itself, seldom leads to hyperinflation. He concludes that hyperinflation is the result of substantial output shocks that result in goods scarcity relative to the supply of money.
Jeremy Grantham discusses why rapidly growing countries are less likely to have high returning stock markets. He concludes that the best returns come from countries with low and stable rates of growth and inflation because they don’t tend to see resource or labor inflation and the banking system can more easily make adjustments when growth changes are small.
A final note. I am seeing more closing of small company stock funds these days. This is causing me to wonder if the small cap sector is close to its cyclical peak, since that is what fund closures have signified in the past.
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