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A 10% Correction Now Or A 20% (Or More) Bear Market Later On
Via ConvergEx's Nichaolas Colas,
If U.S. equities feel brittle, they should. Even though the S&P 500 is up 2.6% on the year, all that gain has come since early April – Q1 was a washout for large caps with the headwind of a stronger dollar. Valuation of 18x current year earnings means domestic stocks are priced for perfection in a distinctly imperfect world: negative revenue growth for multinational companies, increasingly negative earnings comparisons, and a domestic economy stuck in (at best) first gear.
Yes, central bank liquidity from Japan and Europe may well push global equity markets higher. But what we really need is a pullback – that classic 10% correction that flushes out weak hands, reestablishes the discipline of “Risk” in the “Risk-Return” equation, and shows capital markets how to do more than just follow central bank liquidity. So watch June’s price action in U.S. stocks very carefully, because this process needs to start now. The bull market that began in March 2009 is now an ancient bovine indeed.
After all, better 10% now than 20% or more later in the year. The first is inconvenient. The second is unwelcomed.
One of the greatest – if largely forgotten - stories from ancient Greece is a text called the “Anabasis”. Written by soldier and writer Xenophon around 400 BC, it tells of 10,000 Greek mercenaries stuck deep inside the Persian Empire and very far from home. Their sponsor, Cyrus the Younger, had managed to get himself killed and with no local sponsorship the 10,000 have to retreat all the way from what is now Baghdad to the Black Sea, some thousand-plus miles to the north. On the way they have to fight not only Persians but local tribesmen, find food and shelter, and all the while hold military order. Against all the odds, they make it to a Greek colony on the Black Sea and then home. While a retreat is rarely a victory, the Anabasis did give another Greek named Phillip of Macedon the idea that a motivated and small group of soldiers could actually defeat the mighty Persians. His son – Alexander the Great – put that vision into action. And then some…
Fast forward to 1970s New York City, and the (now) cult classic film “The Warriors”. A small gang petty thugs has to make its way from the northernmost bit of the Bronx to Coney Island in south Brooklyn after being wrongly accused of killing a powerful gang leader named Cyrus. On the way, they encounter other gangs, police, and all the mayhem for which 1970s New York was rightly known. They do eventually make it back to the shores of Coney Island, just as the 10,000 made it to the coast of the Black Sea. Yes, “The Warriors” is a direct take-off of the “Anabasis”, right down to the shout out for the long dead Persian king Cyrus.
The message is therefore the same in both narratives: a successful retreat in the face of overwhelming odds can be rightly considered a victory. Consider that as you look at the 5 year chart for U.S. stocks. The S&P 500 is 94% higher over that period, with small caps (+101%) and mid-caps (+101%) up slightly more. But any retreats along the way? Hardly. The last pull back of any note was in mid-2011, when the S&P 500 declined by 17% and bottomed in early September. It’s been over 1,300 days since then.
So how deep are we in “Enemy territory”, and would a retreat be wise at these levels? Consider the following:
Just as an army – even a retreating one – travels on its stomach, equity investments need earnings to survive a long march. More particularly, they need the promise of future earnings growth. And that ingredient is missing at the moment. First quarter earnings for the S&P 500 this year were $26 on an operating basis ($22 with “one-time” charges included) versus $27 last year ($25 as reported). For the second quarter, estimates from S&P show a $28.57 estimate ($26.67 as reported) versus $29.60/$27.47. It isn’t until Q3 2015 that we begin to see projected improvements of $29.97 versus $29.60 last year for operating earnings, and $28.08 versus $27.47 as reported.
Also important to consider: analysts have a predictable tendency to estimate high and bring their numbers down over time. Those Q3 numbers could, therefore, be too optimistic. Regardless, just the data for Q1 and Q2 shows that U.S. large cap companies are solidly in the grip of an “Earnings Recession”.
Bad things happen to good companies, so is that bottom line bump in the road already in stock prices? It doesn’t seem so. S&P is showing a 2015 earnings estimate for the 500 index of $116/share, putting the current year earnings multiple at 18.2. Interest rates are low, to be sure, at 2.2% on the 10-Year Treasury so a P/E ratio that’s college-aged shouldn’t be a shock.
Still, an +18x multiple is typically a valuation measure consistent with only 2 expected outcomes. The first is earnings expansion typical of a classic “Growth stock”. If a company or sector can grow 20% a year, many investors will pay 20x earnings to go along for the ride. Since no one expects 18% earnings growth from the companies of the S&P 500, we need to look to classic “Value investor” math. In this paradigm, markets see through the valley of a cyclical dip in earnings power to the next upswing. Unfortunately, most value investors want to see earnings multiples of 12-15x to feel properly compensated for the risk that things don’t work out as expected. That implies that the S&P 500 would need to earn $141-176/share in 2016 or 2017 at the latest. S&P’s current estimate is for $133/share for the 500 stock index in 2016.
Doing simple math entitles you to tutor your 8 year old, not manage a portfolio, so let’s look beyond valuation. Over the last 5 years investors have learned one (and a half) things. The first is that you want to own equities where central banks are buying long dated bonds. That worked well in the U.S. during the Federal Reserve’s quantitative easing (QE) program, and it has been equally profitable in Japan and Europe. The half-a-thing markets have learned is to hedge the currency out of this equation.
But what happens when one central bank – in this case the Federal Reserve – decides to normalize their policy? Granted, the exit from QE has been easy since the European Central Bank and the Bank of Japan collectively took up the slack with their own programs. The S&P 500 is up 9.8% over the last year and the last new high was all of 6 trading days ago. But just consider the volatility we’ve seen in currency and fixed income markets over the past month. Yes, equities have been nonplussed by all the drama, but can that be a permanent feature of what is supposed to be a riskier asset class?
The “Anabasis” is probably good reading not only for U.S. equity investors, but for the Federal Reserve as well. We have no doubt that they would strongly prefer to “Retreat” from their zero interest rate policy, after all, and get to a short term cost of funds that is historically more normal. We’ll know more about how they consider that decision later this week, when we see the May Employment Situation Report. Any number close/over versus consensus (currently around 225,000) would be a bugle call for retreat among equity investors since it would mean the Fed is one step closer to raising rates. A result below 100,000 might actually be good news for stocks, since it would reduce the chance of a 2015 rate hike. You would, at the same time, have to write off hopes for earnings growth in 2015 and that would limit any gains based on current valuations.
Either way, investors should remember that sometimes a small retreat on your own terms is better than a long march to the sea.
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So if the bull goes another year or two do we get even deeper discounts to BTFD?
Bite the bullet or swallow a cannon ball.
Not another 10%, 20% later prediction. This doesnt even qualify as a complete thought process. Who cares if it corrects 20% sometime later, the way this market has been going it is meaningless for those who own it now.
CAN YOU DIG IT!?
YES I CAN!
*clinks together bottles of potassium cyanide on his fingers*
Shooort-seellllers, come out to plaaaayyy.
Ah, another admirer of the arts, I see. I'd rather watch that movie than Star Wars any day.
"...And I've been waiting such a long time - for today..."
Now pot up the cow bells...
I dug the Lizzies.
How about a 50% correction now
Beat me to it.
My thoughts exactly.
and it would still leave the market overvalued by many time tested metrics.
Thank you! I started reading this article and thought exactly the same thing and then thought 'if somebody else has not already said this then I definitely will'. I am really glad that I am not alone with my opinion of this.
-Addendum; you know, I am beginning to surmise that the almost daily drop at open is just the PTB testing to see if there is any support out there for these prices. Then when, again daily, they see there is no support they ramp up to maintain their 18k, 2.1k and 5k line in the sand.
Very good observation R!
Looks like there's no follow through on their efforts to get upside momentum going.
Think they'll give up and let it drop like a rock as it should?
Only when THEY are completely ready.
That would make my day, and make my accounts flush with cash. Volatility has to return at some point, and when it does I have a feeling it will be like a tornado tearing through a stick built subdivision in Kansas...
A 10% correction? That's all this "market needs"? Jesus fck.
What is this "correction" thingy you speak of, sir?
OK, I really wanted to hate this article but then there's this little gem right in the middle of it:
"Fast forward to 1970s New York City, and the (now) cult classic film “The Warriors”"
OK, so I loved that movie. I wanted to be a "Baseball Fury". This is as good as it got until Snake Plissken came along in 'Escape From New York'.
I drifted off in blissful rememberance and concerned myself with this article... no more.
Snake Plisskin? I thought you were dead!
The choice of 10% may be right (given a Fed tighten) - but 20% as the other choice is WAY under reality. If the bubble is not deflated then it will surely pop (someday) and that pop is going to take down a couple of big entities. When they go you will see leveraged positions unwind and (some) things will likely drop 50% or more. The over leveraging has driven the market higher - so the unwinding is going to hurt just as much on the way down!
The issue are the easy cheap credit markets closeing them would force selling and your looking at over 80% correction from this point. To leave them open you get hyperinflation in credit markets we are nearly there now. You can't turn back what is locked in, these markets are locked in.
The "Current System is Not Sustainable", duh... Hear it from the "Maestro" and two of his horses mouths!
/www.youtube.com/watch?v=pfpEHwARhvc
U believe the Frank Lloyd Wright of Interest Rate Architecture, the foul breathed inscrutable 'maestro' who thru low interest rates for 20 yrs laid the groundwork for the most horrific ripoff of the 99% EVER concocted, and handed the entire global financial market to his brethern, the Jews?
At your own peril.
Sorry, we need to start at 50%, and if we hit a 70% correction, you can start to dollar-cost average in again.
So much for the next crash that will make the last crash look like sound austrian economics.
Even 20% is laughable at best. Start with 50%, then go from there.
20% off the S&P 500 (from, say, the 2166 level) is about 1735.
Sounds about right. A good start.
A final low of 530 SPX would be a hefty 75% discount off the presumed top.
Yeah...all the biggest scam of all time needs is a 10% correction.
10% correction and V shaped recovery - I'M READY!!!
The current market expansion has been a policy decision, not an economic one ... but a propaganda one.
To accomplish the propaganda, they had to change the definition of earnings. We now live in an adjusted ebitda world where the answer to the question of how much profit was made is: How much do you want it to be?
Because of massive misallocation of money/investments, we have skipped past the part where investments create profits and value adding jobs and instead gone right to bidding up the stock price using computer control.
Who would have thought that the most bid up stock are primarily involved in:
1. spying on people
2. propaganda
3. vice
with a bunch of money still going toward murder, stealing the resources of the world and destroying other people's stuff.
Isn't it interesting that both Greece and Persia are still at the forefront of world events
Cue up the feds, Dial a Crash machine.. pick a Number Folks and the Fed will hit it. you want 10.325% You Got it...
10% pullback is perfect for The Pozni Munchkin to come in and introduce QE4.
Quitting while your ahead isn't necessarily quitting.
The question is who is ahead?
The Fed? Wall Street? The ''1%"?
Yes, all three and more that I can't conjure up right now. The point is with the fed 'quitting' the 'market' is forced to fall back on its fundamentals (try not to laugh too hard) and volatility will be back on the front page.
Whatever decision the Fed makes will be (eventually) the wrong one. This is one underlying fact of history that cannot be denied. They are great at ' solving crisis' (again don't laugh) but have NEVER stopped one - always caused it.
Bring on the rate hikes.
Shemitah my man...Shemitah
Can't violate God's law forever
Any "correction" whatsoever will lead to significantly more corporate failures and subsequent lay-offs. This will result in the mother of all viscious circles ending in complete economic collapse. Remember, the "markets" stand alone in their bullishness and so as doubt and then fear emerge, there will be nothing left to curb the epic fall. The "markets" are broken, the global economy is flying blind. Mind that wall there.
A 20% correction would start the margin calls from hell. Now we're talking 40% correction.
The problem is that a 10% correction now would turn into a 60% correction soon after.
You base your proposition on a myth and a movie?
C'mon........
"After all, better 10% now than 20% or more later in the year."
Math would give a 90% correction to such a stock bubble. People forget what math did in 1929-32.
"Either way, investors should remember that sometimes a small retreat on your own terms is better than a long march to the sea."
Math says a long march to the sea is coming anyway. The bigger the bubble, the bigger the bubble to collapse.
The Shenshen is parabolic. All parabolics collapse. A 10% correction is meaningless if the DOW is going to go to 40,000 in a parabolic blow off, as Martin Armstrong suggests is possible.
Ha! We need a 20% correction NOW and a 50% correction later just to have a fundamentally-based 'market'...
Perhaps you mean the actual value of the market after it's correction will be 10% of what it currently is. That makes more sense.
OK, lettuce say you sell now to "avoid the correction". What about the chumps who buy from you? How will they avoid it? The reality is that in the aggregate, these paper losses cannot be avoided. Someone will take them, you can just hope it won't be you.