Road Ahead Won't Be As Easy

In early March the S&P 500 plummeted to a level most investors thought they'd never see again in their lifetime.  At 666.79, the S&P was down 58% from its October 2007 high. 

The intraday low on March 6 lined up almost exactly with the closing level on June 21, 1996.  That was a stunning development for a multitude of reasons.  The most stunning factor perhaps was that the crash of 2008/2009 meant the stock market had gone literally nowhere over the course of a nearly 12-year period. 

It would be remiss not to add that the total return for the S&P 500 during that period, which includes dividends, was 26.8%.   Nonetheless, the lack of price appreciation called into question the virtue of buy-and-hold investing.

Today some order has been restored to the buy-and-hold school of thought knowing that the S&P has gained as much 51% from its intraday low in March.  Undoubtedly, the people who timed that move perfectly are few and far between, but if you held true to the buy-and-hold philosophy, you have enjoyed every bit of it.

Still, the rally is some cold comfort for most people given that the S&P 500 is down 37% from its all-time high.  An even colder thought is that the market would have to gain another 50% just to get back to 1500. 

It might be true in business that the second million is easier to make than the first million, but that doesn't hold true for the stock market.  The next 50% will be a lot harder to make than the first 50% -- and it will take a lot longer to make, too.

Cyclical Bull, Secular Bear

The rally that has unfolded since March has been fueled by the thought that the worst-case economic scenario isn't going to unfold.  We aren't going to have another Great Depression. 

Monetary and fiscal policies have been designed to prevent a depression, yet some unintended consequences are no doubt gestating in those very same policies.

In due time the market will be battling higher inflation as a consequence of the ultra loose monetary policy and higher taxes as a consequence of the free-spending fiscal policy. 

Those factors alone are enough to make us think we are witnessing a cyclical bull market within a secular bear market.  However, those aren't the only reasons.  Other factors include:

• A prolonged period of unemployment/underemployment
• Increased regulation/government intervention
• Consumers' inability to spend freely
• Newfound attention to raising one's personal savings rate
• Potential deflation risk
• Two excruciating bear markets in less than 10 years that have left stock investors (new and old) more risk averse
• Continuance of a weak housing market
• Demographics
• Changes in asset/geographic diversification

A Return from the Brink, but...

The reality of the situation today is that the earnings and economic news has been good enough to spur a trading rally, but it is a long way still from being at a point where it can sustain a long-term bull market.

What is likely to unfold in the next few quarters is that the GDP data will reflect the return from the brink.  Inventories will be restocked to meet basic demand, exports will rebound from depressed levels as stimulus measures abroad take hold, government spending will increase, business investment should stabilize, and the pace of decline in residential construction activity will slow. 

The rate of change in a number of GDP components will improve simply because things fell so far.  In effect, the U.S. economy is destined to improve on technical factors alone.

Like the stock market itself, though, it always comes back to fundamentals and the fundamentals of the U.S. economy can't be described as strong when taking the following into account:

• 1 out of every 6 people over the age of 16 lacks full-time employment
• manufacturing capacity utilization is at its lowest rate (64.6%) since records began in 1948
• existing home sales are down 33% from their peak
• 9.1% of residential loans outstanding are delinquent
• the average workweek of 33.0 hours for production workers is at its lowest point since records began in 1964
• real personal spending is down 1.8% year-over-year
• exports are down -21% year-over-year and imports are down -31% year-over-year
• commercial and industrial loan growth is down -3.3% year-over-year
• real disposable personal income is down -1.0% year-over-year
• there is an ongoing downturn in the commercial real estate market

A Disconnect

The market, of course, isn't trading on these depressing statistics.  It is trading on the idea that these numbers, and others, will only get better as the bulk of the stimulus funds start to filter through the economy, inventories get restocked, the housing market continues to recover, and hiring activity picks up.

The disconnect for us is that the market is acting as if this will be a linear economic recovery and that a lasting return to average real GDP growth (3.4% for 1929-2008) is right around the corner. 

We don't think it is.

Granted the economic data is going to look encouraging in the near term as we bounce off such a depressed base and the stock market is apt to respond favorably to that message. 

We don't think there will be a sustainable quality to the improvement, though, because the main driver of the U.S. economy (and the global economy for that matter) is the U.S. consumer and he/she isn't going to be spending like they used to. 

The U.S. consumer literally can't afford to with as much as $13 trillion of net worth having been destroyed during the simultaneous housing and stock market crashes, and with household debt at 127% of disposable personal income and loan standards having been tightened considerably.

A Ticket to Low Growth

The great irony of this time is that the U.S. government is creating conditions that would allow consumers to borrow more at lower rates when they are struggling to pay their existing debts in the face of a rising unemployment rate and stagnant wage growth.

On the latter note, we expect this period will play out as another jobless recovery that will leave an uncomfortably high number of people unemployed and/or underemployed for a lot longer than anyone would like.  Accordingly, this is going to feel like a recession for a lot longer than the economic data says it should.

The main effect of that sense of things will be more conservative spending.  That isn't something Americans, or the world, are accustomed to seeing in this modern age, but it will be the ticket to low growth in the years ahead.

Earnings growth, therefore, isn't expected to measure up like it did in years past. 

There will be periods like the fourth quarter of 2009 and the first quarter of 2010 where earnings growth looks extraordinary as the financial sector anniversaries the lowliest of comparison periods.  However, with hiring activity not expected to pick up in a meaningful fashion, and end demand expected to remain relatively weak due to continued deleveraging and an increased penchant to save money by the consumer, we see an increased risk to the earnings expectations picture as we move closer to the second half of 2010.

In other words, we think indications of a recovery in the near-term will be a head fake.

R-E-S-P-E-C-T

Our economic view notwithstanding, we still have to respect the market's view of things.  It is clearly seeing things differently -- or at least it is behaving as if it is. 

We are not going to acquiesce to the market's rose-colored economic view, but we respect the idea that the market has a hypnotic way about it that can convince the masses much better times lie ahead.  The strongest influence there is rising stock prices that fail to correct to any meaningful degree which, in turn, feeds a fear of missing out on further gains for sidelined investors.

There is still a lot of sidelined money, too.  Total money market fund assets stand at $3.63 trillion, according to the latest report from the Investment Company Institute.  That is down from a peak of $3.92 trillion in mid-January, but remains above the year-ago level of $3.50 trillion.

The inflated level of money market fund assets reflects the idea that capital preservation is still at a premium for investors, as does the understanding that an estimated net $19.6 billion has flowed into equity funds since the start of March versus $135.8 billion for bond funds.

A Little Weightlifting

The fear of missing out can push stock prices higher in the face of relatively weak fundamentals and can keep prices up long enough for fundamentals to catch up so that the trade becomes self fulfilling.  This is a risk to our guarded stock market outlook and it is a key reason why we are raising our target trading range for the S&P 500 from 825-1000 to 850-1100.

The forward four quarter consensus EPS estimate is $66.93, according to Thomson Reuters. 

At 14.9x forward four quarter earnings today, we think the market is fairly valued.  The market, though, has a mind of its own and can stay overbought for longer than one might expect, so it is plausible that there is an extension of the rally over the near-term as economic data looks comparatively better and participants anticipate easier earnings comparison periods.

Mindful of the latter view, and recognizing there is still long-term appeal in buying into the market at 37% below its peak, it makes sense to stay invested in core positions and to continue with systematic investments in retirement plans.

However, one needs to be more attentive than ever in managing their holdings.  The days of buy-and-hold-and-forget are behind us.  Look to secure some gains in big winners if you have them, or at least take steps to insure those gains. 

Secular bear markets will have their share of ups and downs (some bigger than others, like we're seeing now). 

Accordingly, we'd be hedging with a barbell investment approach that includes ample exposure to both cyclical and non-cyclical groups, with a slight preference for cyclicals knowing the market's recovery bias still remains intact.  The preference here should remain toward high quality companies with strong balance sheets.

The risk that economic activity proves disappointing in the quarters ahead remains real, though, and that is why we don't think one can cut back heavily on their exposure to non-cyclical and income-oriented investment vehicles just yet.

--Patrick J. O'Hare, Briefing.com