After a weak January, the equity markets rallied sharply in February (S&P500 up 4.3%) to historic highs, as investors concluded that bad weather was mostly responsible for the previous disappointing economic numbers. Despite the strong February rally in U.S. stocks, many foreign stock markets have underperformed and recent weak economic numbers in China and Japan, in our view, confirm our general thesis that the global economy is not improving, and overvalued risk assets are vulnerable as the Fed reduces the level of monetary accommodation.
Despite the recent rally, the S&P 500 is flat for the year, and while further modest gains (3% to 5%) are possible over the next few months, we continue to believe the stock market offers an extremely poor risk-reward, 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
Investors are too optimistic and 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
Recent weakness in international markets is a sign of the slowing global economy.
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, the current market cycle is mature 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 managing portfolio volatility. We increased our gold allocation in February and our asset allocation remains defensive:
While the U.S. stock market quickly rebounded to all-time highs after the sharp January sell-off, other major global equity markets continue to struggle:
In fact, while many ebullient Wall Street economists and strategists determined there is no economic slowdown and the recent weak U.S. economic numbers were weather related, disappointing economic data appeared in China and Japan, the second- and third-largest economies in the world.
Despite the unprecedented level of Japanese QE stimulus--designed to weaken the Yen, increase exports and grow the economy--Japan announced a record trade deficit and very weak Q4 GDP growth of 0.7%. This weakness is especially unsettling as the over-leveraged country prepares to increase its consumption tax, which may cause further economic weakness.
While Japan struggles economically, China may be in the early stages of a financial crisis. Over the past five years, China has had a massive credit boom, in which the corporate bond market increased tenfold to $12 trillion, which is 120% of GDP (U.S. corporate debt is 78% of GDP).
Recently, the Chinese government became concerned and took steps to deflate and reform the highly leveraged financial sector. The Chinese financial markets came under pressure when Shanghai Chaori Solar Energy Science and Technology Co., a solar manufacturing company, was allowed by the government to default on its debt; this was the first-ever Chinese bond market default.
We are concerned that China's government-induced, debt-liquidation cycle could snowball into a serious financial crisis due to the rapid growth and massive size of the debt market, probable malinvestment, questionable collateral and uncertainty regarding future government interventions.
If the economic and financial problems in the second- and third-largest economies continue, economies elsewhere will be negatively affected. Both countries have deflationary problems-- anemic domestic demand, manufacturing overcapacity and too much debt--and are export-driven nations that will weaken their currencies to accelerate growth, which will export their deflation to the U.S. and the rest of the world.
Is this time different?
As discussed last month, we believe the recent economic problems in the emerging markets (and now China and Japan), could be the "canary in the coal mine;" or the first economies and markets to be negatively affected by the global reduction in liquidity. We continue to believe that as the Fed continues to taper and global liquidity declines, risk assets will remain vulnerable, while asset bubbles and misallocations of capital manifest.
The economic and financial weakness in the second- and third-largest economies and the potential for deflationary contagion is especially troubling because we have not resolved the structural imbalances that led to two 50% stock market crashes (peak to trough) over the past 14 years. In fact, many excesses appear to be greater today than they were six years ago:
Over the past six years, an increase of $8.74 trillion of debt and $2.84 trillion of base money grew the economy by only $2.5 trillion; as a result, we have more debt relative to GDP than when the financial crisis hit in 2007-2008. Unfortunately, instead of addressing the previous imbalances and letting markets clear, the Fed's aggressive six-year monetary policy response to the financial crisis -- 0% interest rates, negative real rates and QE -- led to more debt, increased mal-investment and asset bubbles.
We are not predicting another 50% stock market crash, but, given the large debt burden, the bloated Fed balance sheet and already low interest rates, we are concerned that the Fed's monetary policy response to a future crisis will be limited and the margin for error diminished, should asset bubbles deflate and global economies slow unexpectedly.
we believe the five-year global bull market is coming to an end and risk assets offer a very poor risk-reward as interest rates, profit margins and valuation levels are poised to "regress to the mean."
While the U.S. markets appear resilient, despite weak economic numbers, global economies and financial markets have begun to diverge. Global liquidity, the most important driver of asset prices during this cycle, has peaked and as the Fed tapers QE and the Chinese attempt to deflate their credit bubble, liquidity will diminish, asset bubbles will manifest and risk assets will decline.
Although four-to-six-year liquidity cycles are common, we are concerned that few excesses have been resolved, while many have grown since the last financial crisis. And the Fed, the lender of last resort, by maintaining extraordinary measures for the last six years may not have the monetary tools to arrest a deflationary crisis if one were to occur.
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.