It’s almost too quiet these days in the capital markets. Despite the Wall Street MSM continuing to pump the theme “everyone hates equities” and aside from the fact that the anemic trading volumes on the US equity markets (and equity markets in developed markets in general) may just support the fact that everyone hates equities, the noise volume of those complaining about the high US equity valuations and the artificial risk asset support programs from central banks in the developed markets has definitely been turned down the last two or three weeks. I even see knowledgeable people like Paul Krugman taking what could be called “victory laps” stating that the government intervention has prevented the developed market economies (especially in the US) from completely tanking and all that is needed is even more of the same. Who knew it was so easy.
Wall Street solved the problem of disappointing reported earnings relative to the sell-side consensus in 3Q12 by simply lowering the bar so low for 4Q12 that more companies got to ride the bell curve. Except, instead of riding the curve up like back in school, on Wall Street companies get to ride the sell-side consensus earnings curve down. Go figure.
Despite the lack of complaining (some have called it capitulation), in my view, it’s still not yet time to get worried about even a 10% pullback in the S&P 500. There’s too much artificial support for the US equity market while the automated trading programs are in control of things. A correction of more than 10% will need a fundamental trigger. I won’t speculate on timing, but the downward trigger will be macro related and will involve leverage. A currency carry trade gone bad, etc.
You had a chance to observe a mini event of what I’m talking about just play out the last six months with Apple (AAPL) stock (to show you an example).
Everyone was piled into the same long side trade and very leveraged. The trade worked like a charm for so long, no one thought it could could go bad. And with the help of Wall Street analysts’ AAPL $900 to $1000 per share price targets supporting the unrealistic trade a lot of people got burned badly being long AAPL stock. But even Apple is not big enough in the overall scheme of things to take down the entire upward US equity trend.
The people who do their homework and position themselves on the short side of the trade that will result in that 20% to 25% developed market equities correction will make themselves a lot of money. Similar to the 2006/2007 to the fall of 2008 US housing/mortgage short trade, the people who capitalize on the upcoming developed market equities short trade will be relatively few, but the payoff will be quite large. The more I think about it, the more I realize they should keep their mouths shut for now.
Remember, before I sound too pessimistic. This is not 1999 with the Shiller PE above 40. The US equity markets are not insanely overvalued like they were back then. US large cap equities are overvalued now relative to the historical average, but I expect nominal mid single digit average annual returns (about 7% nominal) for large cap equities over the next 10 years. See Giving Way to the Gods of Destruction. Add in 2% annual inflation, and the best one can probably hope for is 5% real average annual gains the next 10 years. Some say 7% nominal is crazy given how weak the US and global economy is.
But given the active developed market government and central bank support for the developed market capital markets (the politicians thinking is that high asset prices, regardless of whether the underlying cash flows can support the prices or not eventually help the economy. And their voting base which saves their jobs. High asset prices also help deal with bad loans at the banks). One has to take these factors into account and realize we may not (at least until something really bad happens, which no one can really speculate on) see the developed market large cap equities valuation correct to an undervalued state relative to the historical average. I won’t even get into small cap valuations in the US equity markets.
Part of it is psychological, people on Wall Street firmly believe the government and central banks will step in if big trouble starts and they set themselves up to front run the government backed long equities and long US treasuries trades. Part of it is the fact that large cap companies in the S&P 500 have operationally played globalization very well. Their operating margins jumped to all-time highs in relatively short order once the dust settled from the 2008/early 2009 sell-off. They don’t need the US economy to be that great. That said, every cycle comes to an end and I anticipate the large cap company operating margins to at least flat line the next two or three years before a long-term decline back to slightly above the historical average (reflection of the new reality) from the current high levels.
In my view, 7% nominal average US equities returns are a risky bet to take aggressive long positions given the inherent risk in equities. I’ll personally consider aggressive long-positions when valuations suggest likely returns around the 10% average nominal level (based on the S&P 500). This will require two things:
1) The biggest requirement is the global economy and the US economy hold up and preferably real growth gets into the 2.5% to 3% range at least (right now real growth in the US is probably closer to 1.5% than it is to 2%).
2) The general nominal price level of US listed large cap equities either goes down in a good sell-off of at least 20% to 25% or flat lines for a long while to justify the current levels as the global and US economies grow.
If another recession hits the US (Europe is in recession now), maybe even the US Fed won’t be able to save things.
Until next time.
**Note: Sorry about not posting much on the VR View blog the last month. I’m working on getting research out the door to pay the bills and getting the web site up to speed (still more work to do there…need to build a gallery of all the important graphs). I’ll try to be more consistent on the blog postings going forward.