Sunday, November 15, 2020

The S&P 500 could see a decline of up to 40 percent

Even with its biggest weekly setback since the early days of the Covid-19 pandemic in March, a small group of technology-related stocks remain well up for the year, as evidenced by the 70% gain in the NYSE FANG+ Index. This select group of 10 companies consists of such household names as Facebook Inc., Inc., Netflix Inc. and the parent of Google (hence “FANG”).  The broader market isn’t doing as well, with the S&P 500 Index up only around 1% for the year and the New York Stock Exchange Composite Index down some 11%.

Sure, there are plenty of reasons for the explosion in these stocks. The companies are forecast to have huge earnings in future years, which when discounted back to the present at today’s low interest rates results in large numbers that many believe justify the lofty stock prices. The risk-free 10-year Treasury note yields about 0.85%, and with that as the discounting rate, $1 in earnings 10 years out is worth 92 cents today, almost 50% more than the 61 cents if that discounting rate were 5%. The same concept is imbedded in substituting earnings yields, which is the inverse of sky-high price-to-earnings ratios. For the S&P 500 Index as a whole, the 3.8 earnings yield looks much cheaper in relation to Treasury security yields rates than its 26 P/E ratio.

FANG mavens also note that these businesses are relatively independent of the basic economy, which looks to drop well into 2021 as the pandemic intensifies and spreads. In fact, these companies benefit as people work from home, order goods online, play computer games and watch movies. Then there is the TINA argument -- There Is No Alternative – with bond yields so low. I’ve never understood why investors buy stocks for appreciation but assume there is none in bonds. But as Treasury 30-year bond yields dropped from 14.6% in 1981 to a recent 1.64%, the resulting price appreciation was the key reason that total return for Treasury bonds have beaten the S&P 500’s total return by 5.5 times since the early 1980's.

If I’m correct in forecasting a prolonged, deep recession with escalating global deflationary pressures, the 30-year Treasury yield could easily return to the 0.98% low on March 9, representing a 19% total return over one year. Meanwhile, the S&P 500 could drop 30% to 40% as disappointing earnings combine with plummeting P/E ratios.

Most important, investors’ focus on a small group of tech companies implies trouble ahead for all equities. That clearly was the case with the Nifty Fifty stocks that riveted investors’ attention in the 1960s and early 1970s. These equities represented rapidly-growing companies, some based on solid long-term growth prospects, while others were simply fads. Overconfidence became so extreme they were labeled “one decision” stocks. They had so much promise that investors only needed to make one decision—to buy them—since they would never need to be sold.

Nevertheless, disappointments began to multiply and the favored few shrank to motor homes (Winnebago), hamburger chains (McDonald’s), amusement parks (Disney) and gimmick cameras (Polaroid). They represented the limbs and outward flourishes of the economy, not the basic guts. By shunning the rest, investors should have anticipated big trouble. The 1973-1975 recession resulted in what was then the deepest since the 1930s, and what was left of the Nifty Fifty collapsed. Panicked investors lopped a zero off of Polaroid’s stock price, as it fell from $140 to $14.

Then there was the dot-com equity dominance that preceded the tech collapse in 2000, the bank stock bonanza that peaked in 2006 and energy stocks that plunged along with crude oil prices after leaping to a new high share of the S&P 500 in 2008.

Another sign of equity investor discrimination in favor of tech stocks is their rejection of steady dividend payers, even though low interest rates should make attractive these 65 companies that have at least 25-year records of paying and increasing dividends. The S&P 500 Dividend Aristocrats Index yield of 2.7% tops the S&P 500 dividend yield of 1.7% and is more than triple the yield on the 10-year Treasury note. Nevertheless, investors have yanked more than $40 billion from dividend-focused mutual funds this year following their $3 billion withdrawal in the same period of 2019. That index is down 4.47% year-to-date.

As the many examples of earlier speculations show, investors’ flights of fancy ultimately collapse, leaving many poorer investors gnashing their teeth. Nevertheless, speculative periods often last for longer and go much further than rational analysis suggests. That’s because they have left the realm of reality for the land of zeal, hope and imagination that has no logical limits.

Speculations require a continual influx of true believers that move stock prices from the basis of reality to the stratosphere of hope. They end when the pool of new entrants is exhausted, often due to a shock of reality. Washington’s zeal to curb the power of certain tech companies may be that shock. Note that the NYSE FANG+ Index is already down 8% from its Sept. 2 peak. 

via bnnbloomberg

Thursday, August 20, 2020

Stocks could fall 30 to 40 percent from its recent highs

There is no shortage of investors shrugging off the latest leg lower in U.S. Treasury bond yields, saying heavy central bank involvement in this part of the financial market make such moves less of a signal that the economy or that equities are headed for trouble. That interpretation would be a mistake.

Recall that yields on 30-year government bonds started to decline on Jan. 2, anticipating the fallout from the budding coronavirus crisis that had taken hold in China. Yields fell from 2.34% on that day to 0.94% on March 9, as the price of the benchmark 30-year bond leaped 29%. Only on Feb. 19—seven weeks later—did the S&P 500 Index begin its 35% slide. Fast forward and 30-year yields have fallen from 1.66% on June 8 to a recent 1.19% as their prices climbed 9%. The question is whether stocks will follow again, and with a similar lag of about seven weeks.

The fundamental economic scene favors a repeat. The situation is ghastly, with Covid-19 infections accelerating and plans for physical classes at many schools, colleges and universities this fall risking further contagion. Staying closed or holding virtual classes, however, promotes dropouts, pressure to cut tuition and fees and financial disaster for many schools. Then there are the problems of reopening businesses, re-establishing and reorienting supply chains and encouraging many to return to work who are now paid more by federal and state unemployment benefits than when they were employed.

The recent Treasury bond rally fits with our forecast that the recession has a second, more serious leg that will extend well into 2021, despite massive monetary and fiscal stimulus. Declining business activity saps private credit demand and makes Treasuries shine as havens. A deep recession also breeds deflation to the benefit of Treasuries. The government said Thursday that its core personal consumption expenditure index, which is what the Federal Reserve uses to track inflation, fell 1.1% in the second quarter.

Over the entire post-World War II era, the correlation between Treasury bond yields and inflation as measured by the Consumer Price Index is 60%. This is remarkably strong considering all the other possible influences on long-term interest rates such as federal budget deficits, wars, consumer sentiment and spending, and government actions. My forecast of Treasury bond yields starts and ends with my projection of inflation.

The spread between 10-year Treasury Inflation-Protected Security yields and conventional 10-year Treasury yields, which is what bond traders expect inflation to average over the life of the securities, recently dropped to a miniscule 0.50% from 2.5% in 2012.

Treasury bond investors concentrate on inflation, Fed policy and not much else. In contrast, equity mavens worry about a whole host of often conflicting issues such as corporate finances, profits, price-to-earnings ratios, to name just a few.

Sure, the Fed has been buying Treasuries and along with other fixed-income securities, so its assets have exploded to $7 trillion from around $4 trillion in February. Nevertheless, all this Fed-created liquidity hasn’t found its way into the real economy, as shown by the collapse in the velocity of money.

Then there is the argument that, except for a handful of technology shares such as Facebook Inc., Inc., Apple Inc., Microsoft Corp. and Google-parent company Alphabet Inc., the stock market continues to be weak. Goldman Sachs Group Inc. notes that these five have added more than a third to their market values this year, despite the sharpest recession since the Great Depression.

The S&P 500 is up 0.5% for the year thanks to the strength of those five companies, but the other 495 members are down about 5% on average on a market cap-weighted basis. Still, that 5% decline pales in comparison to the earlier 35% plunge in the S&P 500. Goldman Sachs calculates that if those five tech stocks were to fall 10%, the bottom 100 in the S&P 500 would need to jump 90% to offset the decline.

A Tale of Two Markets

Tech stocks have benefited from their relative independence from the nuts-and-bolts economy. Also, they’ve gotten a boost from homebound Americans who have replaced face-to-face contact with telecommunications. But they are very expensive and under fire from Washington and Europe for anti-competitive practices. And fads end. Recall the craze for Socks the Puppet and his dot-com buddies in the late 1990s. When that bubble broke, the Nasdaq Composite Index plunged 78%.

Also recall the so-called Nifty Fifty group of stocks in the early 1970s. When the only companies of interest to investors made gimmick cameras, ran amusement parks and built motor homes, it was clear the basic economy was in trouble. What followed was the severe 1973-1975 recession and deep bear market.

I believe the bond rally signals a renewed drop in stocks, with the S&P 500 down 30% to 40% from here as the great depth and length of the recession hits home.


Wednesday, May 6, 2020

Gary Shillings on big governments getting bigger

Gary Shillings talks about US Government policies and what can be done to improve the US economy and encourage people to work.

The corona-virus pandemic and its devastating effect on the U.S. economy has ensured that big government–the one that’s already spending some $4.7 trillion in the current fiscal year–is poised to get even larger. As in past crises that led to massive government interventions, new initiatives will largely stay in place once the business downturn ends to the long-term detriment of the economy, despite the “temporary” intentions of these programs.

Ronald Reagan once likened a government program to “the nearest thing to eternal life we’ll ever see on this earth.” A look at history suggests that once a new program or a new agency is established, with few exceptions, it stays established, regardless of whether it was intended to be temporary, whether it’s still needed and whether it actually solved the problem it was created to address.

Before the 1930s economic collapse, there was no federal safety net. State and local governments as well as charities generally looked after the less-fortunate, there were few pension systems in the U.S. and Washington’s role in providing assistance was minimal. The federal budget in 1929 amounted to about $3 billion, or 3% of total output, a fraction of today’s $4.7 trillion budget that accounts for some 21% of gross domestic product. That number will surely grow as federal spending surges, the  economy shrinks and tax collections fall.

The Great Depression marked the start of far-reaching and long-lasting federal government involvement in the economy as Washington strived to blunt the impact of the economic free-fall. The New Deal saw the establishment of numerous “alphabet agencies,” many of which still exist but only bigger and more costly.

The CCC (Civilian Conservation Corps), TVA (Tennessee Valley Authority), REA (Rural Electrification Administration), WPA (Works Progress Administration), FDIC (Federal Deposit Insurance Corp.) and the SEC (Securities and Exchange Commission) were among some of the first New Deal agencies. They were followed by the establishment in 1935 of Social Security, which has grown into a $1 trillion behemoth that is now at risk of running out of money.

The first food stamp program was established in 1939 and ran for four years, followed in 1964 by the establishment of the program that today is called the Supplemental Nutrition Assistance Program and costs close to $70 billion annually.

The 1960s Great Society efforts saw tremendous increases in federal involvement in many areas of American life, almost all of which have survived to this day, starting with the establishment of Medicare and Medicaid, whose costs continue to multiply. These programs eventually widened to include child nutrition, education, rural and urban development, affordable housing, air and water pollution levels, consumer protection and the availability of arts funding. Meanwhile, the Departments of Transportation and Housing & Urban Development were created during the Johnson administration along with the Environmental Protection Agency.

Disdain for government in general was a big factor in Reagan’s election, but despite his declaration that government was the problem and not the solution, the vast federal bureaucracy remained intact during his presidency and has only grown. The Departments of Energy, Education, Veteran’s Affair and Homeland Security are entrenched, and the Consumer Finance Protection Bureau survives despite being a top target of Congressional Republicans.

Meanwhile, Social Security and Medicare benefits have been greatly expanded, and many federal programs created over the past 90 years remain in existence, some with changed mandates and others with questionable results. The REA succeeded in supplying electric power to farms and rural areas, but vestiges of the agency remain in place today. 

I can find only a few agencies that have been eliminated outright, starting with the Civil Aeronautics Board, which was established in 1938 to oversee aviation services and dissolved when the airline industry was deregulated in 1978. The Synthetic Fuels Corp. was established in 1980 to spearhead production of alternative fuels, but it ended up funding just four synthetic fuels projects, none of which survive today, before being abolished in 1986. With the recovery of the financial system from the 2008 crisis, some provisions of Dodd-Frank have been scaled back but key measures, like large bank stress tests, remain.

All the trillions of dollars of federal corona-virus money to support income and jobs will require new bureaucracies to oversee disbursement of the funds. But once the money has been released and spent, what will happen to all those government agencies? If history is any guide, they and their constituents will come up with some rationale for the continued need for their functions.  

Furthermore, the power and reach of the federal government has been magnified greatly as the Federal Reserve, with its gigantic money-creating ability, has become, in effect, an arm of the Treasury Department. Its latest $2.3 trillion program lends directly to states, cities and mid-size businesses and even supports previously investment-grade corporate bonds that are now junk-rated. The central bank’s portfolio of assets, $4.2 trillion in February and now $6 trillion, may be headed for $10 trillion, or almost half of GDP. And the Treasury will cover $635 billion in bad Fed loans.

The labor participation rate for working-age American males has fallen steadily since World War II, in part because many find disability and other government payments more attractive than gainful employment. This has contributed to the slow growth in productivity and the economy, especially in the last decade. The likelihood that the corona-virus pandemic’s income supplements will persist beyond the recession implies that these trends will accelerate. The resulting slow growth in corporate profits will be a drag on post-recession stock prices.

via bloomberg opinion

Tuesday, February 18, 2020

Jerome Powell is a practical Fed Chairman

The U.S. economy has experienced its slowest recovery from a recession in the post-World War II era, and the longer it lasts the more evidence there is that normal cyclical patterns are missing. And their absence means market participants shouldn’t rely on them to divine the economy’s future.

Consider the myriad developments that are atypical, or even the reverse of normal economic and financial market behavior. The Federal Reserve shifted from easing credit to tightening following past downturns, with its target federal funds rate normally raised within a year or so of the recession’s trough, eventually precipitating the next economic contraction. This time, the central bank kept its policy rate at the recessionary low of essentially zero until Dec. 2015, 78 months into the recovery. And then, after nine quarter-percentage point increases, it reversed course early this year with three rate cuts.

Far from the Fed’s normal worries about an overheating economy and inflation, the central bank frets that low and even declining consumer prices will spawn deflationary expectations. Buyers will hold off in anticipation of lower prices. Inventories and excess capacity will mount, forcing prices down. The price cuts confirm suspicions and purchases are delayed even further, sparking a deflationary spiral. The glaring example is Japan, with deflation in most years in the past two decades and tiny real GDP annual growth of 1.1%.

Also, despite the plunge in 30-year fixed mortgage rates from 6.8% in July 2006 to the current 3.7%, rate-sensitive single-family housing starts have been muted. They fell from a 1.8 million annual rate in January 2006 to 350,000 in March 2009 as the subprime mortgage market collapsed, but have only recovered to 940,000.

Mortgage lending criteria have tightened and prime-age first-time homebuyers don’t have the necessary downpayments. The net worth of households headed by 18-to-34-year-olds dropped from $120,000 in 2001 to $90,000 in 2016, a 44% decline adjusted for inflation. Also, they learned from the last recession that for the first time since the 1930s, house prices nationwide can fall.

In past business recoveries, the U.S. household saving rate fell as consumer spending grew faster than incomes.  In this expansion, it’s the reverse, leaping from 4.9% to 7.9% in November, retarding spending.

Past postwar recessions spawned financial problems, but nothing like the 2008 crisis. The government’s reaction was equally severe with the enactment of the 2010 Dodd-Frank Act and other stringent regulations for financial institutions that are only now being slowly relaxed.

In earlier business upswings, a drop in the unemployment rate of anything like the plunge from 10% in October 2009 to the current 3.5% would have spawned massive wage inflation. This time, real wages are barely growing.

Globalization transported many high-paid manufacturing jobs to China. With the growing “on demand” economy—think Uber Technologies Inc. —many people trade flexibility in working hours for low pay. The payroll jobs that are being created are mostly in low-wage sectors such as retailing and leisure & hospitality.

For years, foreign policy was bipartisan and expanding trade was considered highly desirable. Now, globalists have been overcome by protectionists, spurred by voters upset over stagnant purchasing power and rising income and asset inequality in G-7 countries. Trump’s 2016 election along with the U.K.’s “Brexit” from the European Union are among the results. Then there’s also the demise of global trade deals, which are being replaced by bilateral agreements or no pacts at all.

The U.S.-China trade dispute will no doubt persist because China, with a declining labor force as a result of its earlier one child-per-couple policy, needs Western technologies to grow and achieve its worldwide leadership ambitions. But the U.S. is opposed to the technology transfers China wants.

The dollar’s slide from 1985 until 2007 encouraged U.S. exports, curbed imports and gave U.S. multinationals currency-related boosts to profits. Since then, the dollar index has rallied 33% amid a global demand for haven assets. And it should continue to, given the relatively faster growth of the U.S. economy, its huge, free and open financial markets and the lack of meaningful substitutes for the greenback.

Disinflation has reigned since 1980, but real interest rates were positive until the last decade.  But for 10 years now, real 10-year Treasury note yields have been flat at zero (see my Nov. 19, 2018 column, “Zero Real Yields Are Tripping Up Investors”).  This and the flat yield curve have pushed state pension funds and other investors far out on the risk curve in search of real returns, bidding up stocks to vulnerable levels.

Earlier, the Fed was run by Ph.D. economists who clung to widely-held theories even though they didn’t work. Fed Chairman Jerome Powell is proving to be much more practical, backing away from rigid Fed policies such as the 2% inflation target and a zero-bound policy rate as well as unsuccessful forward guidance.

In this different economic climate, it’s hard to time the end of the current recovery. Still, it will end, due either to Fed overtightening or a financial crisis, like the 2000 dot-com blow-off or the 2007-2009 subprime mortgage collapse. In the current excess supply-savings glut-deflationary world, it’s likely a recession will unfold due to a shock before the Fed overtightens.

No financial crises are in sight, but there are possibilities such as excess debt in China and among U.S. businesses, a trade war escalation, consumer retrenchment resulting in widespread deflation, and disappointing corporate profits measured against sky-high stock prices. Watch for specific imbalances, not typical past patterns.

via aawsat, bloomberg