Back in January 2012, all was well with the centrally-planned world: Gluskin Sheff's David Rosenberg was staunchly bearish, while his arch-nemesis, Wells Capital's Jim Paulsen, was the opposite. This rivalry culminated with Rosenberg writing an extensive breakdown of his showdown with "bullish strategist" Paulsen at a CFA event (see "David Rosenberg Explains What (If Anything) The Bulls Are Seeing [13]") in which he said that the one thing that he could "identify as market positive" was valuations, to wit: "we do understand that P/E ratios at current low levels do serve up a certain degree of confidence that there is some downside protection to the overall market here."
Fast forward three years, and the world, while still centrally-planned more so than ever now that the BOJ has and the ECB is about to join the massive monetization fray, has been thrown into conventional wisdom turmoil. The reason is that while David Rosenberg infamously flip-flopped from bear to bull (although supposedly he may be contemplating turning bearish again [14], though who knows after the last 3-day rally) three years ago, none other than permabull Jim Paulsen has come out with a very uncharacteristic and skeptical assessment of the market, in which he does not urge readers of his monthly letter on economic and market perspectives to yet again go all-in and BTFD, but to instead realize that the correction is not yet over and that he expects "a more fearful investment culture suggesting a final capitulation and more importantly, a lower stock market valuation level able to withstand a less hospitable recovery."
First, Paulsen's take on the torrid market rally unleashed by the worst jobs report in years:
Finding a bottom in the stock market may well be a fool’s game, but that does not stop us fools from trying. A strong rally last week accentuated by a surprisingly weak jobs report on Friday allowed the stock market to successfully retest its initial August correction low for the second time. This show of technical strength has buoyed expectations of a coming year end market rally.
While equities may be finding renewed upward momentum in the current quarter, our guess (and it is just that) is the stock market correction is not yet over. In our view, a quick recovery back near all-time highs would leave the stock market with many of the same vulnerabilities that started the correction. Consequently, we would not be surprised if the stock market tests its correction low yet again and perhaps even fails before reaching a final bottom.
Paulsen addresses what he views as the four main challenges for the market:
Despite the weak jobs report last week, the U.S. unemployment rate remains poised to fall below 5 percent within months. Consequently, even modest economic growth can now produce wage and price pressures, mandate higher interest rates, lower both stock and bond valuations and force Wall Street to finally wave goodbye to its great liquidity friend. Simply reviving Chinese economic growth or bottoming commodity prices may not end this stock market swoon. Today’s turbulence is more about correcting market vulnerabilities built up over the past six years, and finding a new foundation that will allow this bull market to resume as the U.S. economy moves toward full employment.
In our view, the stock market faces four major challenges.
First, in recent years investors have become more calm and confident than at any time in this recovery. Undoubtedly, investor confidence has cracked a bit during this correction. Some quantitative measures of investor sentiment now suggest bearishness (a positive for the stock market).
However, while debatable, our current qualitative assessment of investor mindsets is that they remain fairly constructive about the future. Most media stories are not preaching the end of the world and most Wall Street strategists have maintained bullish year end targets. Moreover, financial market action is not consistent with real fear. There has been no huge and sustained rush to the safe haven U.S. treasury, U.S. dollar or gold. Finally, cyclical stock sectors have done as well or better than traditional defensive sectors in the last couple months. Industrials, consumer discretionary and emerging market stocks have been outperforming in the last couple months. Since its start, the premise behind this bull market has been “climbing a perpetual wall of worry”. Today, though, rather than a risk, most seem to perceive the current correction more as a buying opportunity in an ongoing bull market. Once this correction finds its final bottom, we suspect many more investors will likely fear a full-fledged bear market and a heightened risk of recession.
Second, at its recent peak, the trailing price-earnings multiple on the U.S. stock market reached almost 19 times earnings and is still about 17.6 times today. Trading at 19 times earnings in a recovery with a zero interest rate, low and stable inflation and no cost-push pressures is not problematic. However, the stock market is likely to go searching for better valuation support if the normal tensions associated with a recovery nearing full employment begin pressuring the financial markets.
Third, after six years, the U.S. earnings recovery is showing signs of aging. Profit margins are near all time record highs and compared to the last few years, earnings are likely to grow much more slowly during the balance of this recovery. Since profit margins cannot rise much higher, should sales growth remain tepid so will earnings results. Alternatively, should sales growth accelerate, pressures on profit margins are likely to intensify nullifying much of the positive impact of stronger economic growth and keeping earnings performance tepid.
Finally, whether it is this year yet or in 2016, the U.S. is imminently headed toward an interest rate reset. Does the current relatively high price-earnings multiple, an investment community which mostly perceives the correction as a great buying opportunity, a recovery with amazingly weak productivity and an aging corporate earnings cycle represent a good foundation for stocks to withstand a rate hike?
Where does Paulsen see the market heading in the near-term:
Most likely, the contemporary bull market is not over. However, the current correction may prove deeper and longer than most now expect. Should the stock market quickly return to its recent highs, the vulnerabilities that produced this correction will remain challenging.
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Maybe the S&P 500 declines below 1800 before this correction finds a final bottom. A second break below the initial crash low in August would produce widespread fears of recession and calls for the end of this bull market rather than the popular "buy on the dip” mentalities recently evident. Moreover, and perhaps most importantly, near 1800, the S&P 500 would be selling about 15 times trailing earnings (close to its long-term 145 year historical average), which represents a much more sustainable level in an economy facing slower earnings growth, somewhat higher inflation and rising shortterm and long-term interest rates.
Admittedly, there is nothing scientific about 15 times earnings. Perhaps, the stock market will find good support at 16 times or maybe it will need to fall to 14 times? Who knows? It is guesswork at best. However, we think the stock market still faces some vulnerability and until it achieves a better fundamental footing, it is not likely to sustain a meaningful advance.
As a reminder, it was none other than David Tepper who one month ago infamously lowered his own "fair value" P/E multiple from 18x to a range of 14x-16x, noting that under these parameters the S&P 500 would trade between 1680 and 1920 within the next six to twelve months, or 1800 at the mid-point, using a $120 2016E EPS. We wonder if Paulsen was listening...
Finally, Paulsen's summary:
The strong stock market rally during the last few days has pushed the S&P 500 near its highest closing level since the correction began in late August. This has boosted optimism that the recent selloff may be ending. While this could certainly prove to be the case, we remain less sanguine that the vulnerabilities, which initially produced this correction, have yet to be resolved.
Ultimately, we expect a more fearful investment culture suggesting a final capitulation and more importantly, a lower stock market valuation level able to withstand a less hospitable recovery as the economy nears full employment.
So to summarize, among the more prominent recent (perma)bull to bear conversions we have Tepper, Icahn, Gundlach and now, arguably, Paulsen, who may not be "bearish" but who clearly is not a happy buyer here. On the other hand, the bulls are Gartman and Cramer. Trade accordingly
