Submitted by David Stockman of Contra Corner blog,
The attached Barron’s article appeared in December 2007 as an outlook for the year ahead, and Wall Street strategists were waxing bullish. Notwithstanding the advanced state of disarray in the housing and mortgage markets, soaring global oil prices and a domestic economic expansion cycle that was faltering and getting long in the tooth, Wall Street strategists were still hitting the “buy” key. In fact, the Great Recession had already started but they didn’t have a clue:
Against this troubling backdrop, it’s no wonder investors are worried that the bull market might end in 2008. But Wall Street’s top equity strategists are quick to dismiss such fears.
Indeed, with the S&P 500 at an all-time high of 1460, the dozen top Wall Street prognosticators surveyed by Barron’s anticipated still more index gains during 2008:
….. the dozen seers we’ve surveyed all have penciled in higher stock prices in 2008, although their estimated gains vary widely, from 3% to 18%. On average, the group sees the Standard & Poor’s 500 at 1,640 by the end of next year….
That 12% gain didn’t happen! The market ended 2008 in an altogether different place—–that is, about 45% lower at around 900. And is shown below it still wasn’t done, until the capitulation low was reached in early March 2009 at 675.
In truth, this Barron’s article needs no time stamp. Every one of the arguments being made today were trotted out in almost identical form then. Front and center was the usual canard that the market is cheap on a forward PE basis. For what was surely the 17th time in as many years, Goldman’s Abby Joseph Cohen claimed the market was trading at well below its long term multiple:
….the S&P 500 trades today at just 15.6 times average 2008 estimated earnings — well below the average P/E of 18.6 times earnings during periods when inflation was at similarly muted levels in the past 57 years, notes Goldman’s Cohen.
There were three big clouds in Cohen’s perennially bullish crystal ball.
First, inflation didn’t stay so benign. During the next year oil soared to $150 per barrel, bringing the CPI up by 2.9%.
Secondly, 2008 earnings did not come in at $100 per share per the Wall Street hockey-stick, but plunged to $55 on a so-called “ex-items” basis (excluding one time or non-recurring expenses which continuously seem to recur anyway). And actual 2008 earnings for the S&P 500 came in at just $15 on a honest GAAP basis as reported to the SEC under penalty of criminal charges for deliberate misstatement.
But most importantly, Cohen’s 57 years of historical benchmarks were irrelevant. That’s because these historical cycles reflected a reasonably vibrant mechanism of “price discovery” based on traders assessing, weighing and perpetually re-calibrating the in-coming facts from the macro-economy and individual company performance. But by December 2007, price discovery had long ago been destroyed by the Greenspan era policy of financial repression, wealth effects and the Fed’s “put” under the market averages.
Like now, the short-interest had been driven out of the market and, as is evident from the chart above, the fast money crowd had been handsomely rewarded for buying the dips—-confident that the Fed had their backs. Indeed, the bullish case was overwhelming pinned to the expectation that the Fed and other central banks would not let the economy falter, and that a new round of interest rate cuts and other stimulus initiatives would keep the party going:
THE STREET’S BULLISH consensus is particularly impressive considering that all 12 strategists also take a dim view of the U.S. economy’s prospects and expect the Fed to keep cutting interest rates to spur spending.
….Although Wall Street was bitterly disappointed by the Fed’s decision Tuesday to cut interest rates by just a fourth of a percentage point instead of a half-point, more rate cuts could be on tap in 2008, both in the U.S. and Europe. In the meantime, the U.S. central bank took a bold step Wednesday to ease the global credit crunch by announcing plans to offer up to $40 billion in special loans to banks in coming days. Central banks in Europe and Canada are planning similar measures.
Meanwhile, the facts on the ground in the financial markets were getting worse by the day.
Stock buybacks and cash M&A deals were at peak historical levels, thereby adding further momentum to a market that was already trading upward on a one-way basis. Likewise, the junk bond market had exploded to new heights, as had issuance of other dodgy late cycle securities like “cov lite” term loans, pay-in-kind junk bonds and collateralized loan obligations (CLOs), which amount to leveraged funds which issue debt against debt.
And this was to say nothing of Wall Street balance sheets which were bloated with giant inventories of sub-prime and other low grade mortgagees waiting to be sliced and diced into CDO’s, CDOs squared and other toxic exotica. All of this financed on the margin with “hot money”—that is, repo and unsecured wholesale credit.
Beyond this, the LBO financing market was totally out of control, sending a tsunami of cash into the stock market to buy out public companies at absurdly high double digit multiples of cash flow. In the Great Deformation, I tracked 30 mega-LBOs during this period which were taken out at a combined market value of about $500 billion, causing $375 billion of fresh cash to flow to stockholders. Like today, the latter was funded with massive new layers of junk bonds, PIK bonds, second lien loans and other bank credit.
Needless to say, the foundation underneath the market was rotten because honest price discovery was no longer operating. The momentum from vast inflows of underpriced debt and dip-buying by hedge funds betting on the Fed’s “put” caused the actual fundamentals to be largely ignored. For instance, during late 2007 the reported LTM earnings per share for the S&P 500 was about $75. That means the actual PE multiple was 19.5X as the Barron’s year-end revelers talked up the market for the year ahead. It was sitting, therefore, at a dangerously high plateau even by historic standards.
When the market plunged by nearly 50% during the latter months of 2008 and early 2009, the speed and violence of the decline was striking evidence that monetary central planning has doubly destructive effects on the financial markets. In the first instance, it causes bubbles to inflate to exceedingly artificial and excessive levels owning to the inflow of cheap cash and momentum chasing bids from the Fed-following fast money. But in the process it also vaporizes the braking and checking mechanisms—such as short-sellers buying to harvest their gains—that allow markets to correct without collapsing.
A case in point is the Russell 2000, which had climbed a 5-year wall of worry from about 350 to 820 as of late 2007. But when the market broke hard after the Lehman event, nearly the entire 20%/year compound gain was ionized in just 15 violent trading days during the next several months. In short, by turning financial markets into gambling casinos, the central banks have sown the seeds of vast and recurring financial instability. Bubble tops get more and more exaggerated. Bubble collapses become increasingly swift, violent and overdone.
Needless to say, after six years of ZIRP, QE and generally far more extreme monetary expansion than occurred in the run-up to the 2008 financial crisis, every one of the bubble top symptoms described above and completely ignored by the Wall Street bulls cited in the timeless Barron’s piece posted below have reappeared. If anything, the carry trades, vast chains of asset re-hypothecation and momentum based speculation is far more extreme than last time around; and the broad market is also once again precariously positioned at the tippy top of its historic trading range.
The honest LTM earnings of the S&P 500, for instance, are now about $100 per share, adjusted for a pension accounting change that did not exist in 2007. So we are right at that very same 19.5X valuation that was posted at the top last time around. But this replay is occurring in a market that is far more precarious—that is, it is faced with interest rate normalization in the years ahead and that will cause earnings to fall. Also, it is a market that reflects profits rates on income and GDP that are off the charts historically, and are far more likely to regress to the mean than stay perched at their current nosebleed levels.
And most of all the business cycle today is already 60 months old, but unlike 2007 it is far weaker and less stable. Indeed, unlike the 2002-2007 credit-fueled recovery, this “peak debt” constrained expansion has not even recovered its previous cyclical high based on economic fundamentals like breadwinner jobs, real capital investment in plant and equipment and real household incomes.
So based on the stock chart below, now might be a good time to re-read the Barron’s piece from late 2007. Its real message, as it turned out, was “look-out below!”
By Kopin Tan at Barron’s, December 17, 2007
THE STOCK MARKET HAS JUST EXPERIENCED its most volatile year since the current bull market began. Corporate profits shrank in the third quarter for the first time since early 2002. Record oil prices, housing deflation, rising loan defaults and tighter credit conditions threaten to tip the U.S. economy into recession. And a few weeks ago, it looked as if 2007′s gains might disappear before the first strains of Auld Lang Syne.
Against this troubling backdrop, it’s no wonder investors are worried that the bull market might end in 2008. But Wall Street’s top equity strategists are quick to dismiss such fears.
Indeed, the dozen seers we’ve surveyed all have penciled in higher stock prices in 2008, although their estimated gains vary widely, from 3% to 18%. On average, the group sees the Standard & Poor’s 500 at 1,640 by the end of next year (editor’s note: actual was 45% lower at 903), or about 10% higher than the recent 1486 with global growth and a benevolent Federal Reserve serving as twin crutches for the aging bull.
THE STREET’S BULLISH consensus is particularly impressive considering that all 12 strategists also take a dim view of the U.S. economy’s prospects and expect the Fed to keep cutting interest rates to spur spending. Since September, Fed Chairman Ben Bernanke and his colleagues have lowered the benchmark federal-funds rate three times, to 4.25% from 5.25%, including Tuesday’s quarter-point reduction. Still, none of the leading strategists is forecasting a recession, although one Wall Street economist — Richard Berner of Morgan Stanley — last week predicted a “mild recession,” with no growth for a year.
“We expect the U.S. economy to show the strains of the deflating housing market and credit-market disruptions in early 2008,” says Goldman Sachs strategist Abby Joseph Cohen. But “recession likely will be avoided, due to strength in exports and capital spending by corporations and government.”
Credit Suisse equity strategist Jonathan Morton agrees. “Conditions for a hard economic landing — like slack in the labor market and weak balance sheets — are still largely absent,” he says……
IF THE CASE FOR U.S. STOCKS is built on global growth and lower interest rates, other factors, too, suggest that the market is heading higher. For one, Washington is determined to avert a financial disaster, particularly in an election year, and already has unveiled a plan to freeze mortgage-rate re-sets on some teaser loans to stem an expected wave of foreclosures among troubled borrowers.
Although Wall Street was bitterly disappointed by the Fed’s decision Tuesday to cut interest rates by just a fourth of a percentage point instead of a half-point, more rate cuts could be on tap in 2008, both in the U.S. and Europe. In the meantime, the U.S. central bank took a bold step Wednesday to ease the global credit crunch by announcing plans to offer up to $40 billion in special loans to banks in coming days. Central banks in Europe and Canada are planning similar measures.
Another potential plus for stocks: Investment funds controlled by foreign governments are likely to step up their hunt for attractive assets in the U.S., which still is the world’s largest economy. While buying power has been shifting from consumer countries like the U.S. to commodity producers, “some of that wealth is starting to get recycled back to the consumer countries,” says Morgan Stanley’s chief global equity strategist, Abhijit Chakrabortti. “It isn’t going just to traditional investments like Treasuries, but right to the capital-starved parts of the U.S. market that need it most.”
The latest example is Abu Dhabi’s $7.5 billion investment in Citigroup. Merrill Lynch expects so-called sovereign-wealth funds to double or triple their share of riskier global assets by 2010, nudging the tally to $8 trillion by 2011.
IN 2007, WORRIED INVESTORS LUNGED for the safety of bonds. Treasuries may hold less appeal next year, the Street’s leading strategists say. Many of those we surveyed see the yield on 10-year Treasuries, now near a three-year low of 4%, increasing in 2008, albeit at a genteel pace that won’t spook the market.
The strategists note, as well, that bull markets rarely end when the earnings yield on stocks — now around 6% — is higher than benchmark bond yields.
S&P 500 earnings are expected to climb 4%, to an average of $92 a share this year. The Street’s 2008 estimates range from a low of $85.65 to just over $100. Corporate profits are likely to decline in the early part of the year, but face easier comparisons with ’07 results in the second half.
While some fear this year’s peak profit margins will wane, Bear Stearns’ Jonathan Golub says “margins will prove sticky at a high level” after years of cost-cutting. A 35% decline in leverage (outside of the financial sector) in the past five to seven years has made for healthier balance sheets, and continued stock buybacks are likely to keep boosting earnings per share.
Then there’s the market’s modest valuation. As this year has proven, valuation alone is no reason to buy stocks; a low price/earnings multiple failed to lure buyers frightened by falling profits, surging oil prices and steadily worsening news from the housing and banking sectors. That said, the S&P 500 trades today at just 15.6 times average 2008 estimated earnings — well below the average P/E of 18.6 times earnings during periods when inflation was at similarly muted levels in the past 57 years, notes Goldman’s Cohen.
To many strategists, stocks now discount an economic slowdown. Ian Scott, Lehman Brothers’ London-based global equity strategist, says profits conceivably could fall as much as 45% if the U.S. slips into recession. But the stock market likely would fall no more than 10% to 15% from current levels even in this worst-case scenario. Citi’s Levkovich says prices already anticipate earnings growth that is 20% to 25% below the 20-year average. He calls stocks “screamingly cheap relative to bonds.”
……Merrill’s Bernstein was among those to forecast this year’s surge in stock-market volatility, and he continues to steer the firm’s clients toward high-quality bonds, defensive sectors in the U.S. and consumer-oriented sectors abroad — essentially a play on the rise of the overseas consumer. He also likes large-cap stocks in the U.S. and smaller stocks abroad, as well as dividends and cash for more risk-averse investors.
When Bernstein huddles with money managers these days, the No. 1 question he’s asked is: Are financials cheap? Apparently, he isn’t the only one, and some strategists expect bottom-fishing in financials to become a popular sport in 2008.
Its dangers are clear to see. The Financial Select Sector SPDR XLF -0.56% Select Sector SPDR-Financial (XLF), an exchange-traded fund that tracks the financial stocks in the S&P 500, has sunk 20% this year, to the bear-market depths. Financial-services-industry profits are expected to fall further as loan-loss provisions increase, and if home prices — and related mortgage securities — continue to slide. Tighter credit also threatens to choke off the private-equity and merger boom, and a skittish market has discouraged stock offerings, all of which means lesser fees for big brokerage firms.
Given the depth of the housing market’s decline, which is hard to calculate even at this point, bottom-fishers must be prepared to swim deeper and stay underwater longer. Chakrabortti expects financial-company earnings to fall 5% to 10% in 2008, a stark contrast with the Street’s consensus call for 16% profit growth. He thinks financials could pull back another 20% before “the downturn in this credit cycle is fully discounted.”
Thomas Lee begs to differ, however. “While the first half may look like death, second-half earnings will improve as the rate cuts take effect” and as easier comparisons take hold, says Lee, who became JPMorgan’s main U.S. strategist after Chakrabortti left for Morgan Stanley earlier this year. A year ago, when he was still at JPMorgan, Chakrabortti had advised investors to underweight financials — but Lee now expects the sector to “lead markets higher in 2008, even with the worst of the bad news on structured investment vehicles and write-offs still ahead.”
Rate cuts and a steepening yield curve will help. Also, the financial sector swiftly purges itself of bad businesses and excess capacity — one reason the sector has suffered consecutive bad years only once in the past four decades, and why a down year frequently is followed by double-digit gains the next year, Lee says. He thinks a consensus will emerge in 2008 that financial stocks present investors with the most appealing risk-reward profile.
WHAT ABOUT OTHER MARKET SECTORS? Deutsche Bank Alex. Brown’s Larry Adam likes technology’s global prospects as the world strides toward wireless transmission of voice, data and video. “All those buildings are being built in China, and the next step is to make them more efficient,” he says. The ongoing push to get the world wired spells technology demand.
In addition to benefiting from global growth, technology has no direct exposure to housing. But Bear Stearns’ Golub says that between 20% and 30% of technology spending is tied to the weakening financial sector, and he questions whether that has been considered fully by technology bulls.
Credit Suisse’s Jonathan Morton likes pharmaceutical stocks, despite worries about the political risks to industry profits. Among other things, he says, drug companies have plenty of “self-help potential” — that is, the ability to reduce their sales forces relatively easily, cut costs and take on debt. By levering their balance sheets to just half the level of the market norm, they could raise enough cash to buy back 10% of the sector’s shares.
Consumer-staples stocks have been a popular refuge in times of market turmoil, but this sector now holds limited appeal for Lehman’s Scott. “Valuations have gotten quite high, and pressures from high raw-material costs may not be as fully considered,” he notes.
Consumer Discretionary Select SPDR XLY is down 15% from its July peak. But consumer-discretionary stocks rise and fall with oil prices and the Fed’s benchmark interest rate. As both retreat next year, the sector will enjoy a “double boom,” ISI’s Trahan says.
“The consumer is not dead!” declares Citi’s Levkovich. While the decline in home sales and home values has been pernicious, household net worth increased some $18.5 trillion in the past five years, with just $4.4 trillion coming from real-estate gains. What’s more, the richest 20% of Americans drive 40% of the country’s consumer spending, and their outlays are less restrained by rising gasoline prices and higher mortgage rates.
Compared with the average American, the rich also have a smaller portion of their net worth tied up in homes — and more of it invested in the financial markets…..
Yet if Wall Street’s strategists are right about the market, the rich will get richer in 2008, along with most other equity investors. Chances are, the ride won’t be smooth and the direction won’t always be clear — but by now we’re used to that.