A bearish take on U.S. stocks is about as fashionable as a beehive hairdo at the moment, which makes it a decent time to think like a contrarian. Sell-side strategists with a sense of reality are few and far-between but as ConvergEx's Nick Colas warns, the most important reason for caution currently is, obviously, valuation and complacency.
U.S. stocks currently reflect, both in price level (16x current year earnings) and implied volatility (an 11 handle VIX), an economic acceleration which has yet to fully flower. In addition, Colas adds, domestic equities look good in part simply because everything else – Europe, Japan, emerging markets, etc... - look so bad. Wouldn't an accelerating U.S. economy spill over to other regions?
And if you are of a superstitious bent, consider the ‘Curse of the new Fed Chair,’ where the changing of the guard at the U.S. central bank brings unexpected macro events to test the newbie. Volker (1979 Iranian Revolution), Greenspan (1987 Crash) and Bernanke (2007 Financial Crisis) all faced such trials. So what is lurking around the corner for the next lucky Fed head? And what about the three main memes for why the 'bull' can keep running?
Via ConvergEx's Nick Colas,
Tears Dry On Their Own
Wall Street is, by nature and historical precedent, a superstitious place. OK, maybe not as bad as whatever happens standing on line for a Powerball ticket, but close enough. We count the number of Mondays where the stock market rises, and if it is more than three it gets called a ‘Trend’. Or the first days of the month. Or the quarter. Or the year. Or the election cycle. Or based on which political party holds the White House. All the statistics available to investors makes it easy to torture a trend from the data, in much the same way that working a Ouija board sometimes puts you in touch with your long lost Aunt Agatha. Whether you had one or not.
So in the spirit of, well, the spirit world, I would like to introduce “The Curse of the New Federal Reserve Chairman.” The basic idea is that the U.S. economy tends to face some period of difficulty shortly after a new Chairman of the U.S. Federal Reserve takes the helm. Here are a few data points:
Paul Volcker took the reins at the Fed in August 1979. Just a few months later in November of that year the U.S. embassy in Tehran was overrun by protesters, sparking a high level political crisis between the countries which would not be resolved for over 400 days. Oil prices spike to new highs in 1980 ($37/barrel), levels they would not see again until 2004. The country experienced deep recessions from both the high cost of energy and Volcker’s ultimately successful efforts to curb inflation with double-digit interest rates.
Alan Greenspan started his turn in the corner office (at least I assume the Fed Chair has a corner office) in August 1987. Two months later came Black Monday, on October 19, 1987, when the Dow Jones Industrial Average dropped 508 points - a 23% decline. Stocks still closed up on the year for 1987, thanks in part to Greenspan’s reassurances of financial liquidity in the days after the crash.
Most recently, Ben Bernanke started his tenure as Chairman in February 2006. He got all of an 18 month reprieve from the “Curse” before it became clear that his predecessor might have been a little too heavy handed serving from the punch bowl of monetary policy. At least as far as house prices went...
Based on these trends, you’d think that U.S. equity markets would be a bit cautious walking into the end of Chairman Bernanke’s tenure. And, of course, you’d be dead wrong. Domestic stock markets are showing remarkable resiliency, not just in the face of the “New Fed Head Curse”, but other better known challenges. In fact, U.S. equities are the global go-to asset class at the moment. The S&P 500 is up 6.3% since the beginning of the third quarter and money flows into U.S. listed exchange traded funds which invest only in U.S. stocks are running over $1 billion/day. Non-U.S. equities and fixed income, y contrast, must make do with about $300 million/day.
Look for a bearish market observer and the best you’ll probably do is someone calling for a “Pullback” of 5% or so. That’s actually an even more optimistic assessment than just “Buy them right here” since it signals that superior opportunities lie just ahead. Sort of like passing on a date with your crush because Kate Upton or Bradley Cooper will be walking through the door soon enough.
So let’s play “Devil’s Advocate” for a moment and make the real bearish case – that the current market trend to the upside is at an end and we’ve seen the highs for 2013.
Here’s what that looks like:
Myth: U.S. stocks still seem cheap-ish based on 2013 earnings expectations of $110/share for the S&P 500. That works out to a 15.5x multiple on current earnings, and stock have room to go much higher. How high? Maybe 18 times that $110, or 2000 on the S&P 500.
Reality: Yes, current estimates for S&P 500 earnings sit at $110/share. Want to know where they were in January 2013? Try $112/share. How about a year ago, for 2013? Try $115. And in March 2012? Yeah, higher… over $118. The bottom line is that the S&P 500 isn’t going to earn $110/share. Maybe it will be $108. Or maybe $107… So what do you want to pay for every-diminishing earnings expectations? Hint: It isn’t 18x earnings. It might not be 16x, or where we are today.
Myth: U.S. stocks will grow into their earnings expectations as the U.S. economies recover.
Reality: OK, this one might be true. The problem with the assumption is that U.S. equities have the reputation for being the only game in town at the moment. European economies excluding Germany are still deeply troubled. Emerging markets look risky and in some cases politically unstable. Japan’s monetary policy experiment isn’t yet showing strong results. So what happens when the U.S. economy does accelerate? This will potentially drag the rest of the world with it, making those capital markets look more attractive. So much for the only game in town.
Consider the following: of the $35 billion in money flows into U.S. stock ETFs thus far in the third quarter of 2013, $15 billion has landed in one product: the SPDR S&P 500 ETF. The SPY is now the largest ETF in the U.S. capital markets at $157 billion and represents one out of every 10 dollars invested in U.S. listed ETFs. This isn’t an endorsement or a refutation of the product. The point is that the appetite for U.S. stocks appears to be heavily concentrated in the most liquid index even when other equally efficient options actually have better returns (i.e. Russell 2000).
Myth: There’s still plenty of worry warts out there who haven’t bought U.S. stocks and will need to fill up the tank as equities continue to grind higher.
Reality: Real money doesn’t always trade volatility, but when they do they prefer the VIX. OK, needless pop reference, I know. But consider that the CBOE VIX Index closed today at 11.8. I know that “15 is the new 20” for the VIX, meaning that its long run average of 20 is really more like a 15 reading today. And that’s fair enough with easy monetary policy and a reassuring central bank helping the case. But an 11-handle is just 3 points away from all-time lows for this measure of market expectations as they relate to near term volatility. There are some seasonal factors at play here – August tends to be lower volume and volatility for U.S. stocks – to be sure.
Consider, however, that we also had a wide-ranging terror warning from the U.S. Government over the weekend in anticipation of threats related to this week. Where would the VIX have closed without that caveat? A 10-handle? Nine something?
The upshot of these observations on the VIX and other factors is that you might still be able to make a decent return between now and the end of the quarter in U.S. stocks, but you need to believe that there are no speed bumps on the way. The options market isn’t pricing any real risk in the system – not from Al Quaeda, not from policymaker mistakes, not from Europe, or Asia, or the Middle East. Valuations are cheap-ish, as long as you don’t mind endless downward revisions. Stocks are the only game in town for now. So as long as you want to go along with that rosy assessment, you should be all good.