Originally published February 14th, 2014
The equity markets declined sharply in January and early February as emerging market instability and weaker-than-expected US economic data concerned investors. While the markets may have stabilized in the short run, we continue to believe the stock market offers an extremely poor riskreward, is poised to provide below-average, long-run prospective returns and is vulnerable to a significant decline (30% or more).
Our top down outlook remains unchanged:
- Long-term valuation measures indicate stocks are overvalued by at least 30%
- Historically high profit margins are poised to regress to the mean and yield disappointing earnings
- The economy and profit growth remain sluggish and near recessionary levels
- Investors are too optimistic
- Many asset classes show signs of excessive speculation
- As the Fed shifts its monetary strategy from buying assets (Quantitative Easing) to providing forward guidance, risk assets will be vulnerable
As discussed last month, we believe the excess liquidity (0% interest rates and QE) provided by the Fed, coupled with excessive investor optimism, have driven stocks far above their intrinsic value. As the Fed reduces the level of monetary accommodation, risk assets will be vulnerable as valuations, interest rates and profit margins return to normal levels.
The best way to compound wealth over time is to avoid major losses. Market history shows risk levels vary greatly over time and it is critical to identify and avoid poor risk-reward environments. In our view, we are late in this market cycle and stocks offer an inadequate risk-reward. To mitigate risk, we have reduced our equity exposure, increased asset diversification (cash, bonds and gold), and are limiting asset volatility. Our current asset allocation remains defensive; the recent increase in market volatility and the stock market's loss of momentum have led to a reduction in our small cap equity exposure, as well as an increase in our intermediate-term bond exposure.
Market Commentary: As previously discussed, we believe risk assets are overvalued and vulnerable as the Fed reduces the level of monetary accommodation (taper QE), and the economy disappoints investors' sanguine expectations. Recently, those concerns came to fruition. Capital markets were under pressure as emerging market countries, with significant current account deficits, suffered capital outflows and currency weakness, as investors pared their risk exposure, unwound leveraged carry trades and sought safe havens. As investors fled these volatile markets, the U.S. reported surprisingly weak economic data, which accelerated the selling of risk assets.
Despite the experts blaming the economic weakness on the weather, the current stability in the emerging markets, and the strong US equity market rally off the February 5th low, we remain concerned. We believe the recent volatility in the emerging markets was the "canary in the coal mine;" as the Fed continues to taper, and global liquidity declines, risk assets will remain vulnerable, as asset bubbles and misallocations of capital manifest.
The emerging markets -- which depend the most on global liquidity to finance their current account deficits -- were, not surprisingly, the first to be negatively impacted by the Fed's tapering. While the currency markets may have temporarily stabilized, their economies remain vulnerable to the higher interest rates and/or lower currencies, and a weakening China.
Disappointing US economic data also hurt the stock market in January and early February. While many blame the weather, we remain concerned that economic growth expectations are too high (greater than 3% GDP) and believe risk assets remain vulnerable as economic and corporate profit growth, once again, disappoint.
Our pessimistic view on the economy is based on our belief that few of the structural economic problems that led to the financial crisis have been addressed. The Keynesian fiscal and monetary policies of the past five years -- deficit spending, growing the size of the government, increasing taxes and regulation, and printing money to weaken the currency -- have not worked. In fact, while the Keynesian demand side policies of deficit spending and printing money may have pulled some economic growth forward, it is evident that these policies also increased the structural economic imbalances:
- Debt outstanding relative to GDP is greater than five years ago (total debt grew $6.8 trillion while GDP grew $2.6 trillion)
- "Too big to fail" banks are bigger (top four banks are 30% larger than five years ago and the top five banks hold more than 50% of total banking assets)
- The Fed's balance sheet is five times larger ($4 trillion vs. $800 billion)
- The labor force is still smaller than it was six years ago (145.22 million in January 2014 vs. 146.38 million in January 2008).
While we are concerned about the increased structural imbalances in the economy, we are also concerned about two important cyclical economic indicators (credit growth and real wages) that are flagging. As shown below, credit growth has dropped to an anemic and recessionary level of 1.2% on a year-over-year basis. In our view, the fact that banks do not want to lend and/or businesses do not want to borrow is a symptom of the excessive (and unaddressed) burdens on the supply side of the economy, namely, too much tax, regulation and political uncertainty.
In addition to the lack of credit growth, it is also disconcerting that after five years of economic recovery, real household incomes remain weak, especially after falling to levels not seen for nearly twenty years.
Real disposable income is an important leading indicator of the economy, because consumer spending accounts for over 70% of GDP and real incomes show the change in living standards of the 90%, or more, of the labor force that is employed. Real wages and living standards must increase or economic growth will not be sustainable. Unfortunately, real disposable income has been disappointing and, incredibly, has not grown more than 3% throughout the entire five-year recovery. It will be very difficult for economic expectations to be met unless real wage growth improves dramatically.
We are also question the impact that the Fed's QE program has had on real wages; the idea of targeting higher inflation, clearly, negatively impacts the living standards of most wage earners and those on fixed incomes.
It is clear to us that Keynesian, demand-side economic policies (deficit spending, higher taxes, increased regulation and printing money) have had little positive impact on the economy, job creation and living standards. In our view, the best policies for a structural debt problem and global excess capacity are not these inflationary policies but supply side and pro-growth.
The best way to grow the economy, increase living standards and mitigate our debt burden is to implement free market policies that incentivize entrepreneurs and businesses to take risks and invest capital. This is best done by reducing the tax burden, decreasing burdensome regulations and maintaining a stable currency. Until such conditions prevail, entrepreneurs and business will not have the incentive to take risks, build businesses and hire employees.
In conclusion: we believe the stock market offers a historically poor risk-reward. At nearly five years old, the bull market in equities is very mature, stocks are at least 30% overvalued and earnings are poised to disappoint as profit margins, which have never been higher, begin to "regress to the mean." Additionally, we expect the economy will remain sluggish until the structural issues are addressed and pro-growth policies are implemented.
In our view, the strong equity market of the past few years is best explained not by solid fundamentals, but by the excess liquidity provided by the unprecedented growth in the Fed's balance sheet. Throughout this economic recovery, whenever the fundamentals disappointed, the Fed increased its balance sheet to provide additional monetary accommodation and stocks rallied despite the weak fundamentals. Currently, the Fed is tapering its bond buying and slowing the expansion rate of its balance sheet in favor of providing the market with "forward guidance." As the excess liquidity diminishes, we believe risk assets are vulnerable and valuations are poised to regress to the mean.
While many will argue the emerging markets have stabilized, or are insignificant, and the weak US economic data is due to weather, we believe the recent market volatility marks the beginning of a correction in risk assets that should accelerate over the next few months as global excess liquidity diminishes and the fundamentals disappoint optimistic expectations.
Our core philosophy is that the best way to grow wealth is to have a long-term investment horizon and avoid major losses. Because profitability levels and growth regress to the mean over time, valuation is the best measure of long-run prospective returns. Currently, the equity markets are overvalued and offer a very poor risk-reward. We believe investors should reduce their exposure to risky assets and be patient until the risk-reward improves and investors are adequately rewarded for assuming equity risk.
Historically, liquidity-driven bull markets deflate quickly and patient investors will be rewarded with great values and significant long-term opportunities.
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