It would appear as though the markets have included the avoidance of pain as one of our inalienable rights, as outlined in the Declaration of Independence. The markets have rallied recently, apparently on the expectation of further action by the Federal Reserve. In fact, the equity markets rallied on a horrible jobs report that showed the number of job openings declined the fastest in over seven years. I know the markets are forward thinking, but this logic increasingly strikes me as strained and the equivalent of a driver excitedly accelerating the car because they see a tree ahead that will stop the car.
Maybe the Federal Reserve gives the markets all they want tomorrow. However, I struggle what would satisfy the markets. I suppose QE3 is what the market wants, but will it have an impact? If so, will the impact ultimately cause more harm than good? Sure, investment spending likely benefits from lower interest rates. But, do highly leveraged consumers need more debt? Can the people in need of low cost financing actually get it, despite the lower interest rates? I continue to believe that the Fed is losing its ability to stimulate demand, instead simply stimulating supply growth. This imbalance results in short-term boosts to the economy as businesses spend but eventually loses its steam as demand trends do not justify the increased investment spending. In short, Sagflation.
Potentially more ominous is my belief that the US economy has been built on a low interest rate foundation. What does this mean? It means that debt service has been low relative to the outstanding debt, enabling over-consumption on the demand-side and over-expansion on the supply-side. In essence, we have been painting ourselves into a corner with the only possible outcomes of depression, default or excessive inflation. Since all of these produce some form of pain, albeit in very different forms, our on-going avoidance of pain likely only leads to excessive pain in the future.
I was also amused by comments on CNBC about the housing market. The bullish bias continues as experts believe the industry should outperform the economy. Commentators take that as a bullish sign about the economy. In my view, the housing market likely outperforms only because mortgage rates keep declining, in essence enabling consumers to manage a larger debt balance and therefore pay a higher price for a house. Looking at it in reverse, when the rate on a 30-year fixed mortgage rises to the historically inexpensive 6% from the current level of around 4% the monthly interest payment for any prospective buyers increases 50%. So the Fed's actions can stimulate industries like housing for the short-term but also encourage excessive debt levels and inflates asset prices.
There is a lot of "hope" out there, but I fear this economy is living on borrowed time.
Tuesday, June 19, 2012
Monday, June 4, 2012
Expected ROIC Drives Stocks. This Likely Isn't Good for the Markets.
Spent some time during the recent market weakness listening to CNBC. Oh boy, the number of professionals simply hoping the market goes up is disturbing. Every possibly justification for higher stock prices was offered, including reversion to the mean, attractive dividend yields, low PEG, central bank intervention, and on and on. The other disturbing observation was the short sightedness of the views. Comments suggesting a Fed intervention is more likely simply avoids the fundamental issues, in my view.
Let me reiterate my very basic, but often misunderstood, argument: Expected Return On Invested Capital (ROIC) is the primary driver of stock prices, based on my experience covering stocks. PEG, dividend yield, and all other valuation measures are symptoms of the changes in ROIC, in my view.
The outlook is moving increasingly deflationary, as the PPI, CPI and PCE Index all moderate. In terms of company financials, this trend likely causes slowing revenue growth and compressing margins. For financial firms it may mean a death sentence to certain products (eg. annuities) or even firms as the yield curve flattens. Harder times for financial firms likely causes more restricted lending and liquidity, further hindering company performance and the economy.
All these trends mean falling ROIC for most companies. Falling ROIC means slowing earnings growth, cuts to dividends, worsening leverage ratios, and reduced investment spending.
I haven't even discussed debt in Europe, slowing growth in China, or the fiscal cliff at the end of this year. These topics are well covered by most financial news sources.
Sagflation - Slow to negative real economic activity combined with more volatile prices caused by aggressive monetary policies. As the "real" income of the average American slows, and even begins to decline due to excessive unemployment and mis-allocation of capital, I expect increasing deflationary pressure in the more middle-to-lower class discretionary segments of the economy as demand slows. This deflationary pressure may be offset for a time by increasingly aggressive monetary policy, but I believe more expansionary monetary policies likely disproportionately raises food and oil price, impacting debt levels of the middle to lower class. Ultimately, our monetary-policy-fueled economy becomes a snake eating its tail, in my view.
My IRA remains about 50% cash, 30% short position, and 20% long equities in specific companies expected to outperform the market.
Let me reiterate my very basic, but often misunderstood, argument: Expected Return On Invested Capital (ROIC) is the primary driver of stock prices, based on my experience covering stocks. PEG, dividend yield, and all other valuation measures are symptoms of the changes in ROIC, in my view.
The outlook is moving increasingly deflationary, as the PPI, CPI and PCE Index all moderate. In terms of company financials, this trend likely causes slowing revenue growth and compressing margins. For financial firms it may mean a death sentence to certain products (eg. annuities) or even firms as the yield curve flattens. Harder times for financial firms likely causes more restricted lending and liquidity, further hindering company performance and the economy.
All these trends mean falling ROIC for most companies. Falling ROIC means slowing earnings growth, cuts to dividends, worsening leverage ratios, and reduced investment spending.
I haven't even discussed debt in Europe, slowing growth in China, or the fiscal cliff at the end of this year. These topics are well covered by most financial news sources.
Sagflation - Slow to negative real economic activity combined with more volatile prices caused by aggressive monetary policies. As the "real" income of the average American slows, and even begins to decline due to excessive unemployment and mis-allocation of capital, I expect increasing deflationary pressure in the more middle-to-lower class discretionary segments of the economy as demand slows. This deflationary pressure may be offset for a time by increasingly aggressive monetary policy, but I believe more expansionary monetary policies likely disproportionately raises food and oil price, impacting debt levels of the middle to lower class. Ultimately, our monetary-policy-fueled economy becomes a snake eating its tail, in my view.
My IRA remains about 50% cash, 30% short position, and 20% long equities in specific companies expected to outperform the market.
Friday, June 1, 2012
Approaching the Main Event?
Performance in May was steady, increasing 1.0% for the month and 3.2% for the year-to-date. This performance is relative to the S&P 500 Index decline of 6.2% in May and a 4.2% increase for 2012. Over the past year my IRA has increased 13.2% compared to a decline of 2.6% in the S&P 500 Index.
Finally June!
My excitement may differ from other investors' excitement about turning the page on May. Right from the start of 2012 I believe I have had a clearer outlook about the second half of the year than the first half. By turning to June I believe my thesis for 2012 can begin to play out. First, a brief review of some of my comments:
On September 23, 2011, I wrote:
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.
Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.
On February 27, 2012, I wrote:
The markets are increasingly worried about rising oil prices slowing economic growth. The rise in oil prices appears related to supply worries associated with Iran, rather than strong demand. However, the increase in the PPI for crude materials has slowed to less than 5% annually, after rising at a rate greater than 15% for the past two years. Aggressive actions by the ECB and Federal Reserve may continue to drive inflationary pressures, but I believe deflation may ultimately take over as the market driver later in 2012.
June 2012 and Beyond
Fast forward to the end of May and the yield on the ten-year treasury is near a record low and the yield on the thirty-year treasury is approaching 2.5%. Among the main driving forces behind the declining yields has been the nearing climax of the debt crisis in Europe with money exiting Europe and piling into US Treasuries. However, pricing dynamics in the US suggests inflation pressures are subsiding. Growth of PPI has continued to slow, even turning negative in April although on an annual basis the increase remained positive but slowed to 1.9%. Oil prices are falling and the CPI index is moderating. Without material actions taken by the Federal Reserve, I believe price increases likely continue to moderate and may even turn negative by the end of the year.
In summary, I believe the equity markets may soon follow the lead of the treasury market, implying the continued decline of valuations as deflationary forces increase debt burdens, slow personal income growth, and squeeze corporate margins.
Under my Sagflation thesis, I argue that the Federal Reserve is reaching the limits of its capabilities to spur demand, instead providing short-term stimulant to supply. Consumer debt was $2.52 trillion at the end of March, just shy of the all-time high of $2.59 trillion at the end of 2008. Furthermore, consumer debt increased 10% y/y in March, suggesting debt outstanding likely hits a new all-time high in the near future. Given there are 5 million fewer people working now relative to 2008, the debt outstanding appears unsustainable. The bulls argue that rising debt levels are a strong indicator of a recovering economy, supported by the the highest consumer confidence in 4 years. Fueling the optimism, in my view, has been the ability to re-finance mortgages and a more healthy job market than in recent history. But, with refinancing activity waning and job creation coming in well below expectations for May, I believe this optimism shifts back to fear.
Finally June!
My excitement may differ from other investors' excitement about turning the page on May. Right from the start of 2012 I believe I have had a clearer outlook about the second half of the year than the first half. By turning to June I believe my thesis for 2012 can begin to play out. First, a brief review of some of my comments:
On September 23, 2011, I wrote:
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.
Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.
On February 27, 2012, I wrote:
The markets are increasingly worried about rising oil prices slowing economic growth. The rise in oil prices appears related to supply worries associated with Iran, rather than strong demand. However, the increase in the PPI for crude materials has slowed to less than 5% annually, after rising at a rate greater than 15% for the past two years. Aggressive actions by the ECB and Federal Reserve may continue to drive inflationary pressures, but I believe deflation may ultimately take over as the market driver later in 2012.
June 2012 and Beyond
Fast forward to the end of May and the yield on the ten-year treasury is near a record low and the yield on the thirty-year treasury is approaching 2.5%. Among the main driving forces behind the declining yields has been the nearing climax of the debt crisis in Europe with money exiting Europe and piling into US Treasuries. However, pricing dynamics in the US suggests inflation pressures are subsiding. Growth of PPI has continued to slow, even turning negative in April although on an annual basis the increase remained positive but slowed to 1.9%. Oil prices are falling and the CPI index is moderating. Without material actions taken by the Federal Reserve, I believe price increases likely continue to moderate and may even turn negative by the end of the year.
In summary, I believe the equity markets may soon follow the lead of the treasury market, implying the continued decline of valuations as deflationary forces increase debt burdens, slow personal income growth, and squeeze corporate margins.
Under my Sagflation thesis, I argue that the Federal Reserve is reaching the limits of its capabilities to spur demand, instead providing short-term stimulant to supply. Consumer debt was $2.52 trillion at the end of March, just shy of the all-time high of $2.59 trillion at the end of 2008. Furthermore, consumer debt increased 10% y/y in March, suggesting debt outstanding likely hits a new all-time high in the near future. Given there are 5 million fewer people working now relative to 2008, the debt outstanding appears unsustainable. The bulls argue that rising debt levels are a strong indicator of a recovering economy, supported by the the highest consumer confidence in 4 years. Fueling the optimism, in my view, has been the ability to re-finance mortgages and a more healthy job market than in recent history. But, with refinancing activity waning and job creation coming in well below expectations for May, I believe this optimism shifts back to fear.
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