Mid-year 2013 Market Overview: The Plates are Shifting

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s. The 1990s had the benefit of being within the Kondratiev Autumn of the long cycle, helped along by the tailwind of falling interest rates and risk spreads (and rising investment valuations) and both consumers and business leveraging up with debt. The 2010s are in the Kondratiev Winter, where interest rates are already low (and risk spreads are already tight, thanks to the Fed's reflationary actions) and consumers are still reducing their debt leverage.

We are heading into the most powerful part of the upwave in both the 15-20 year infrastructure cycle and the 7-10 year standard business investment cycle. Barring some major catastrophe that throws the economy off course, the next 2-5 years are likely to be the best economic years we enjoy in the whole period from 2008 to the mid 2020s, driven by the continued recovery in business investment.

We are probably exiting the "Rounded Bottom" recovery and entering into a US-centric expansion.

So with that background, let's discuss the state of the markets:

Interest Rates

The chart below breaks down the current interest rate yield and risk curves:

Chart One

(click to enlarge)

 

Slide1

As I discussed in "Why Gold is in a Bear Market", real interest rates have risen since my last market update in Q2 2012 "Have Corporate Profits Peaked?" as demand for private investment capital has risen. Private investment remains at levels normally associated with recessions (mainly due to low levels of real estate investment), but today's current level of real interest rates (represented by the interest rate on TIPS in the chart above) is also abnormally low. We are moving from depression levels of real rates to recession levels instead. An improvement nonetheless.

I actually don't think the Fed has helped the yields of treasuries that much…if anything the Fed has kept rates elevated by maintaining inflation expectations in the equilibrium range of 2.25% rather than at the lower levels had deflation been allowed to run its course. Where the Fed has helped the markets is by crowding out private investment from the risk-free treasury bond and government-back mortgage securities market and into the risk markets of corporate bonds and equities. This is evidenced by the lower-than-equilibrium risk spreads even during a relatively weak economy.

The only area where risk spreads are wider than usual is the municipal bond market. Seeing what happened to Detroit recently may make the reason for this obvious. Nevertheless the only cheap asset class in the fixed income market is long term municipal bonds. Floating rate bank debt funds can also make an attractive option to get some spread while hedging against the risk of rising interest rates (which make bond prices fall).

US Dollar

The dollar has been rallying a bit but has remained cheap as the Fed has remained more aggressive on the easy money front than the European Central Bank. Nevertheless as real interest rates rise in the US with increased investment demand, I expect the dollar bull market to continue. Go back to my 2011 piece "Get Ready for a Dollar Bull Market" to see more on why I think we're due and what a stronger dollar means for the financial markets.

Chart Two

(click to enlarge)

Slide4

As we can see in Chart Two above, in nominal terms against major currencies the dollar has rallied to near the top of its long term (downward-sloping) channel. Against a trading basket of all currencies, however, and in real terms (which is what matters economically), the dollar is still weak. This means that the dollar still has alot of potential to rally against emerging market currencies and that the US terms of trade remain pretty favorable (good for exports and US industrial activity).

Housing

The housing market got a good bounce off the bottom in the second half of 2012 and so far in 2013.

Chart Three

(click to enlarge)

Slide5

US housing has gone from being a cheap asset class to a fairly valued one pretty quickly. The stabilized economy and financial system should be good for housing, while rising real interest rates provide a headwind. Its a fine time to buy a house, but not for speculative purposes, assuming the overhang of the bubble will prevent another bubble run to rival the last decade's.

Equities

Figuring out the right price for stocks is trickier. I've long been unenthused about stocks, even as they've risen strongly over the past four years. I've owned them because I maintain a diversified portfolio, but I've felt they are riding the advantages of low interest rates, a cheap dollar, moderate inflation and a particularly capital-friendly environment to artificial heights. That said, the absence of alternative, attractively-priced investment options make stocks seem like the best of a bunch of bad choices.

Here are my calculations:

Chart Four

(click to enlarge)

Slide2

The market is priced at about 16x the $103 earnings assumed by S&P analysts for 2013. That, on the surface, would appear to be fairly priced. I believe, however, that we should price stocks off of long term trend earnings (which smooth out rises and falls in business and inflation cycles) which are currently $66. The 16x multiple (which is the fair multiple) on trend earnings leaves a fair value of the S&P of 1,049, 38% below the current level of 1,686. It should be noted that S&P earnings fell (slightly) in 2012 compared with 2011. Although they do appear to be rebounding in 2013. Perhaps fiscal austerity, a stronger dollar and higher real interest rates won't hurt earnings because the economy is going to move into a higher gear, which I do believe it will.

I have a problem with this alternative hypothesis. The analysis shown in Chart Four shows that my trend line of real earnings shows growth of 2.5% per year over the past 50+ years, which makes perfect sense, as it is in line with or slightly below real GDP growth. If we add a 4.5% equity risk premium to the equilibrium long term treasury bond yield, we get an assumed long term return on stocks of 8.8%, in line with long term performance. If we assume the 8.8% return, and real earnings grow at 2.5%, inflation is assumed to be 2.25% (which is clearly the equilibrium level that has been assumed by the market over the last four years), and we assume the payout yield is 60% (dividends plus buybacks), we mathmatically arrive at the PE of 16x, which is also the historical average (a little higher even). The theory is sound.

So where could I be wrong? My trend line could be using the wrong y-intercept, because it doesn't have data going back far enough. Perhaps if earnings were higher in the 1940s and 1950s, the full long cycle trend would have a 2.5% growth line cutting through today's assumed earning level of $103 as the mid-cycle trend earning level. The other thing that could be wrong is that the equity risk premium has shifted permanently to a lower level, like 3%. Or maybe earnings will continue to grow faster than the economy.

This last chart is what makes me nervous when I try to embrace any of the above theories:

Chart Five

(click to enlarge)

 
Slide3

Corporate profit margins are at a peak level as a percent of GDP. Given the historical pattern (i.e. margins don't seem to linger a peak levels very long), we should assume that corporate earnings start growing more slowly than the economy for a spell. Perhaps margins will continue to hit new records (possible) or perhaps it won't matter because the economy is going to start growing very quickly. I don't see a catalyst to make stocks plunge anytime soon, but I'm weary nonetheless. I will continue to take profits if stocks rise and keep myself hedged. Stockpicking is the name of the game, I think. Large cap growth will likely have the upper hand.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here. 

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