Santa Claus Came To Town

By: Michael Ashton | Tue, Jan 4, 2011
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I think it is good to start the new year, when possible, with a proper dose of humility.

Back in early September (in this comment), I mocked Wall Street strategists' equity forecasts, which at that point called for a 7% rally over the remainder of the year - the bullish forecasts looked for 18%. What really had gotten my goat were not the forecasts, but rather Barron's describing the strategists as "wary" with that call. I pointed out that the 21% annualized rate of increase (53% for the bullish strategists) was certainly not wary, considering the long-run expected return to stocks is around 4.5% plus inflation.

But credit where credit is due: the strategists were right; the S&P gained 13.9% from September 3rd to year-end, so the bullish strategists were even in the ballpark. I think the chart of the S&P, below, since that issue came out ought to support my view that this was actually a rather remarkable call, instead of being "wary", but the bottom line is that they were right and I was wrong. I wish I could figure out how they knew the market would have a four-month straight-line advance, but congratulations all around.

SPX Index Chart
Only thing more impressive than the melt-up is that a bunch of folks called it!

My skepticism, though, is deep-rooted, so I somehow have trouble letting go when I read that Laszlo Birinyi is calling for S&P 2854 by year-end 2013. This is based on the current rally being an "average length and size" bull market. Of course, there is a lot of debate about whether this is in fact a bull market (he is talking cyclical, rather than secular), and even more about whether we can expect an "average" bull market when we are at above-average valuations already, but Laszlo would say that widespread doubt is a sine qua non for starting such a rally.

That rally would represent a 322% gain over the lows reached 22 months ago. Birinyi looks to the bull markets that began 1962, 1982, 1990, and 2002 as his yardstick. Now, since I tend to be a value guy, I will note that in 1962 the Cyclically Adjusted Price Earnings Ratio (aka "Shiller P/E") was 16.8 when the rally began and never exceeded 24.1; in 1982 it was 6.6 and never exceeded 18.3; in 1990 it was 14.8 although it did get to 44.2 in the bubble; in 2002 it was 22 and peaked at 27.5(but most strategists consider the 2002 rally as a cyclical bull within a secular bear). By contrast, the CAPE is currently 23.3. So how much are we expecting out of this market? If earnings also explode, then the P/E can stay in the 20s, but I have trouble seeing the kind of margin expansion that would be necessary to get that kind of surge in earnings.

All of which preceding commentary, of course, needs to be couched in the context of "but I didn't see the big Q4 rally, either."

There is no question that the economic picture is brightening, although I wouldn't say it is brightening in a dramatic fashion. Car sales today were better-than-expected, but are still selling at a pace around 75% of what once was considered a bad month (see Chart, source Bloomberg).

US Auto Sales Chart
Yayyyyy! 9.4mm units!

Just so I am not accused of picking-and-choosing: yes, some of the manufacturing surveys have been better-than-expected. But we need to remember that those surveys measure relative growth (how was this month compared to last month/year) and the output figures like car sales measure absolute output. I suppose Birinyi would say that gives the economy more room to expand, but I would argue those prior levels of output were only sustainable as long as the authorities were willing and able to keep adding leverage. All through the first part of the 2000s, auto manufacturers were offering ever-improving financing deals. Eventually, the steroids ran out. And this goes more broadly for the whole economy.

However, perhaps what equity investors are buying right now is the notion that the steroids are flowing again. The 10-year inflation swap has risen from around 2% at the beginning of September to 2.64% now. The chart below shows the S&P against the 10-year inflation swap. Looking at this, I don't think equity investors are trading earnings at all. They're trading leverage.

4 in 1 Graph
Equities are acting like inflation-protected securities...but they're not.

Stocks, as I have written here many times, are not proof against inflation. And you don't need to see all of the pretty regressions and historical figures I can pull out to prove it to yourself. Just ask, "if stocks are good inflation protection, how did they do in the 1970s?" The prosecution rests.

The ADP report (Consensus: 100k vs 93k) is due to be released tomorrow. Economists are forecasting the highest print since November 2007. I mentioned last month that the fact ADP has been consistently underperforming payrolls suggests ADP ought to outperform and Payrolls to underperform, all else being equal.

Economists are justified in assuming some slow growth in Payrolls. While the significance of last week's widely-touted Initial Claims figure is reduced by the fact that it is from late December (seasonal adjustments are devilishly difficult from now until late January), there does seem to be a slow thawing of the jobs market...but it is very slow, and slow enough that the Consumer Confidence "Jobs Hard To Get" response is still rising. I don't forecast ADP or Payrolls, but if I did so then my forecast would be beneath, but probably statistically indistinguishable from the consensus this month...especially given the variance associated with December initial prints.

Those looking for strong jobs growth in December are hopeful that retail hiring played catch-up in December if sales were in fact stronger-than-expected (that is, stronger than the retailers, not the economists, expected). If that is the source of strength, then it will likely at least partially reverse in January. But here is the rub - ADP doesn't give as detailed a breakdown as does Payrolls. So any enthusiasm resulting from strength in the ADP number will not likely be blunted until Friday.

I believe there is a good equity-shorting opportunity approaching, but I suspect I will probably miss it. The market seems to have forgotten about the European periphery and is addled on holiday eggnog. Too much is priced in, too soon. I don't think we're talking about a 25% decline, but a significant correction is due. But then, I didn't forecast the Q4 blast-off so what do I know?!?



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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