Revisiting the List of Worries

James Altucher suggests that the S&P 500 is going to 1500, an increase of over 40%.  He provides seven good reasons.  He notes that stocks are trading at 11 times forward earnings.  Average would be 15 or more, and the current low interest rates suggest an even higher multiple might be appropriate.  I view valuation on forward earnings as the single best indicator of sentiment since it is dollar and trade-weighted.  James also notes the extreme bearishness of those commenting on his article.  The fine team at Bespoke Investment Group notes that bearish sentiment is back at the levels of July, 2009.  (Check out their typically fine chart).

Many who believe that the low earnings multiple is justified either focus only on past earnings, expect an economic decline, or believe that we are in a new regime where stocks will never again achieve historic P/E ratios.  In past years, this last assertion would be met with some skepticism since we all question those who say "It's different this time."  In the current market environment there is surprising acceptance of a rather extreme proposition.

Mistaken Bearish Predictions

The Altucher column focused on several good positive indicators.  In addition to these factors, we should also consider reduced worries on several fronts.  These are all examples of bearish predictions gone wrong -- topics that were the focal point of discussions for days, weeks, or months, but now seem to be mistaken.

Auto Sales

The popular assertion was that auto sales would collapse after the Cash for Clunkers program.  Most believed that sales would be pulled forward with no lasting impact on the overall trend.  (I was among the skeptics).  Consider the actual seasonally adjusted data from Wolfram Alpha.

You can see the program effect and the later sales strength, up more than 20% from prior levels.  Could the same thing happen after the expiration of government programs for home sales?

Consumer Spending

For many years the most bearish pundits have explained that consumers are "spent up, not pent up."  They have argued that personal consumption expenditures would fall with home prices.  They have (inaccurately) argued that consumers are "70% of the economy" and projected a collapse of GDP with weaker consumer spending.  Let us look at the seasonally adjusted data, once again from Wolfram Alpha.

My guess is that most skeptics do not even know that spending has exceeded the old highs, even with current unemployment levels.  The spending dip was never as great as predicted by the bears and it was very temporary.

Europe and the Euro

Beginning in early May the market collapsed with non-stop coverage of the sovereign debt crisis.  There were to be many defaulting countries.  European and international programs would fail.  Many of the loudest (but not most accurate) voices predicted that countries would drop out of the European Union and the Euro would go to parity with the dollar.  People quickly identified the Euro as a proxy for a "risk trade" that seemed to include almost anything except bonds.

While the European story is certainly not over, the gloom and doom predictions are not supported by actual data.

The Euro has certainly moved lower since May, but it seems to have found a bottom and rebounded significantly.  At one point there were extreme predictions that a small change in the Euro could imply the loss of thousands of points in the Dow.

Taxes

Those with a political agenda have emphasized the impending expiration of the Bush tax cuts.  I have argued that this will actually stimulate a bipartisan approach to the deficit question.

It is difficult for any of us to predict policy outcomes when the specific plan is unknown.  Larry Kudlow's interview with Revenue Secretary Geithner showed flexibility from the Obama Administration on capital gains and dividend taxation.  (Kudlow views this as a shift, but it seems consistent with past statements).

This approach would be market-friendly on both taxes and the deficit negotiations.  The jury is still out on this point, but the prospects are clearly more positive than most believed a few days ago.

Mortgage Rates

Remember how so many predicted that mortgage rates would spike when the Fed ended its purchase program?  Instead, rates have reached record lows.

I understand that many excuses can be offered for this failed prediction, but it was a very inaccurate call.  The Fed exited gracefully from this market.  Once again, it is something to bear in mind as the Fed reduces its balance sheet on other fronts.

Investment Conclusion

There are always many problems.  You can try to look smart by emphasizing the worries everyone knows about.  This shows the viewer/listener/reader/potential investor that the speaker knows what you know.  This message confirms the pre-existing bias of the viewer while establishing a bond.

No one keeps score when the worries are gradually reduced and the forecasts are proven wrong.  More importantly....

There is no edge in investments based upon the front page of your newspaper.

Comments

[James]

As far as Europe, you are jumping the gun with your conclusions. Actually, more and more of economists realize that EU breakup is the best solution to the structural problems that the EU experiment created.

Euro Area Breakup Would Boost Region's Economies
http://www.bloomberg.com/news/2010-07-10/euro-area-breakup-may-boost-economies-from-greece-to-germany-report-says.html

Also, problems for the US are much greater than most realize (except Dagong that has just downgraded US credit rating)

"Dagong said it rated Washington below China and 11 other countries such as Switzerland and Australia due to high debt and slow growth. It warned the U.S. is among countries that might face rising borrowing costs and risks of default."
http://www.google.com/hostednews/ap/article/ALeqM5hoClThrviIt1Jf_nVbVtdc6qQkxgD9GSNHN86

[Ram]

I like the theme of this post very much. A few bearish points

Re: auto sales
1) Looking at a longer time scale, we are still at absolute sales level reached in the late 1960's!
http://calculatedriskimages.blogspot.com/2010/07/light-vehicle-sales-long-june-2010.html

Re: Personal spending
2) Shouldn't you look at "real" spending which by eye-balling may not have exceeded prior highs?
3) Isn't personal income less transfer payments a better measure of spending sustainability?http://calculatedriskimages.blogspot.com/2010/07/recession-measure-personal-income-may.html

Re: mortgage rates
4) Well, folks were expecting the mortgage spread with treasuries to go up by 25-100 basis points. So far, the spread has indeed gone up by 45bps (or 20bps, accounting for risk aversion): not massive but still up as predicted.
http://www.housingwire.com/2010/06/17/mortgage-spreads-stay-low-after-fed-mbs-exit-pmi-economist
5) What is more surprising is the plunge in purchase index to 1997 levels coinciding with the plunge in mortgage rates
http://calculatedriskimages.blogspot.com/2010/06/mba-purchase-index-june-30-2010.html

Thanks for a refreshing blog that is data-focused and, dare I say, fair and balanced :-) I got to know through Maudlin -- so John helps play a connecting role as well.

[oldprof]

Elliot -- Thanks for the link. You have some interesting ideas. More importantly, we should all be trying to think about events (both positive and negative) that are not already in the news.

You illustrate this very well.

Jeff

[oldprof]

Mike C - Coming up with long-term growth rates is a tricky question, especially for an index where the makeup changes. I work on it for individual stocks (where I have many attractive candidates and holdings) but not for an index.

Just for the sake of your thesis, let's say that we take some long-term average in nominal terms. Everyone would still argue about whether we were starting from a point below the trend, etc.

I agree that current prices reflect extremely low growth expectations, which is why I call these valuation measures long-term sentiment indicators.

Jeff

[Elliot]

Jeff:

I really like your perspective and ideas. As you have been saying, it's so much harder to think about what can go right than what can go wrong--it's easy to point out flaws. With that in mind, I put together a post about 3 Black Swan ideas that could go "terribly right" for the economy over the next few years.

http://wallstcheatsheet.com/breaking-news/economy/say-hell-no-to-a-black-swan-free-world/?p=14068/

Regards, and keep up the good work!

Elliot

[Mike C]

Mike C - As I have often noted, I do not want to turn every article into a debate about valuation in the comments. My position is well-known and I try to update it periodically.

Jeff,

You repeatedly make the point that too many such as Shiller, Hussman excessively focus on past earnings.

You know what, you have ***convinced*** me that is at least partially true, and mind you I'm not persuaded easily. So your arguments have been effective in getting me to reconsider and modify my views.

That said, the clear implication of the part I quoted is that you believe current forward multiples are probably too low.

Without getting into the MBA level finance mathematics in this comment, obviously a "fair multiple" is a function of the growth rate. If company XYZ is going to grow earnings 50% a year for the next 5-10 years, then a trailing P/E of 50 is actually dirt cheap. In fact, a P/E of 100 might be too cheap if you know with absolute certainty that is how the future earnings will play out.

So if the position is that forward multiples are too low then the corollary to that is one must have some opinion on future earnings growth rate.

I honestly have no opinion on overall valuation here because I have no good opinion on earnings growth prospects, and my question was to try to get you to expound on that point which really is the key variable. If you think earnings can grow at 10% annually, then I'd like to know why, because you could have a very good argument I'm not familiar with.

I'll play along for one thought. This would be a good question if the stock return currently equaled a corporate bond return. Then we might talk about growth.

Suppose there was 0% growth. Where do you think stocks should trade?

Valuation is always a function of future growth (Buffett has said exactly this a great number of times). The corporate bond return might impact the discount rate one uses to calculate the present value of those future earnings.

A short-hand methodology is basically Ben Graham's formula of P/E=8.5 + 2*growth rate*4.4(AAA yield). With a 0% growth rate, that gets you to basically 8.5, and let's just say 9-10. A 10% growth rate gets you to a P/E around 20, so today's price clearly is discounting some pretty low future growth rates. Again, I have no strong opinion at all because there are so many cross-currents as you highlight about things to be worried about.

I don't follow your last statement about "flip side". Of course earnings matter, they always did, they always will. EVERYTHING ELSE just makes for fun conversation. Where will SPX earnings be in 2015? $70, $100, or $180. If it $180, then stocks are RIDICULOUSLY CHEAP and I should be borrowing every last dime I can to buy as much as I possibly can. Bottom line, I was interested in your opinion on why future earnings growth might surprise to the upside of what is the PIMCO "New Normal" view.

[oldprof]

Mike C - As I have often noted, I do not want to turn every article into a debate about valuation in the comments. My position is well-known and I try to update it periodically.

This article is about the ever-changing reasons that you can find to hate the market. The data changes, the opinions do not.

I'll play along for one thought. This would be a good question if the stock return currently equaled a corporate bond return. Then we might talk about growth.

Suppose there was 0% growth. Where do you think stocks should trade?

Prediction: As PIMCO gets more into stocks, the definition of the "new normal" will change. Meanwhile, this argument sounds like the flip side of those in 2000 who said that earnings did not matter!

Jeff

[Mike C]

Many who believe that the low earnings multiple is justified either focus only on past earnings, expect an economic decline, or believe that we are in a new regime where stocks will never again achieve historic P/E ratios.

What is your rough estimate for SPX earnings growth over the next 3-5 years starting from today's base of trailing 4 quarters? Over the next 3-5 years, will we see closer to 0% earnings growth annualized, 5% annualized, or 10% annualized?