Investors are focused on the potential tapering of U.S. bond buying by our Federal Reserve in 2014. But far less attention is being focused upon another giant risk in the economy; deflation. Deflation in economic terms is a decrease in the general price level of goods and services. Economists postulate that deflation can become a predicament in a contemporary economy because it increases the real value of debt, as prices decline and debt values remains steady. This is what has happened in Japan over most of the past twenty years after their asset bubble burst in 1989. Poor economic growth goes along with deflation. Because the price of goods is falling, consumers have an inducement to postpone purchases until prices fall further, which in turn further shrinks overall economic activity. Investment then also collapses, leading to a cycle of lower demand from consumers. This is what is known as a deflationary spiral. Economists have historically answered deflation through monetary stimulus, either from a governmental central bank or by fiscal means like tax cuts. There are two prominent deflationary periods in developed markets in the past century. The first cycle was in the Great Depression. It resulted from the market crash of 1929, excessive debt, and high extended unemployment. Much of this was exacerbated by the passing of the Smoot-Hawley Tariff Act in 1932. The act resulted in international trade falling sharply while bank failures were rampant. A comparable situation occurred in Japan, beginning with the stock and real estate market collapse in the early 1990s. Japan attempted more “stimulus” to ward off the effects of deflation, with limited results. Japanese 10-yr bonds remain just below 1% today, twenty years after the cycle started in the early 1990s. Until the 1930s, it was recurrently believed that deflation would treat itself. As prices did fall, demand would naturally increase. Famous economist John Keynes argued in the 1930s that the economic system could not self-correct from deflation and that central banks had to take vigorous actions to improve demand through increases in government spending or reduced taxation. We never got a convincing answer on Keynes policy argument. The reason is the data on the 1930s is mixed, especially dependent on which historical economist you ask. Was deflation in the 1930s cured by monetary means or ultimately War World II?
Today, it looks as if global stimulus is not working to combat deflationary forces. While most of the developed world is still practicing expansive stimulative activities, this past quarter’s global economic statistics point to a heightened risk of deflation. The pointed drop in the annual rate of consumer price inflation in the Eurozone in October (0.7% vs. 1.1% for the previous month) looks like a forewarning that the winds of deflation are actually increasing. If so, that is quite an ominous trend given the feeble growth rate in Europe. No wonder the the European Central Bank (ECB) announced an out of the blue cut in interest rates in November. The ECB decided on a 25-basis-point cut (0.25%) of its chief financing rate to an historic low of 0.25 percent, down from its preceding all-time low of 0.5 percent. The preponderance of analysts had believed the bank would not cut rates at this juncture in time. But the cut became necessary with a discernible drop in inflation in the euro area to 0.7 percent in October. Also impacting the ECB’s decision was the stubbornly high unemployment rate of 12.2 percent in Euroland.
Meantime, in our own home country we also have troubling trends. The most concerning estimate of inflation’s trend in the U.S. can be found in the personal consumption expenditure (PCE) benchmarks, as calculated by the Bureau of Economic Analysis. According to recent data, inflation is fading continuously since the fall of 2011. The headline PCE index increased a mere 0.9% in December vs. a year ago, and is now down from the 1.1% annual rate in August (red line in chart below). This was only up from the downtrodden 0.7% rate released in November, a figure that really spooked the markets. The Federal Reserve’s preferred measure of inflation is the Core PCE, which excludes food & energy (purple line) has looked a bit more erratic over time and the most recent data also looks unpropitious. The deflationary trend in core PCE has to be quite disconcerting for our Federal Reserve members, especially considering the lengths the governmental entity has gone to drive the economy forward. In fact, in the 12 months through December, the core PCE price index rose just 0.7 percent, the smallest increase since records began in 1959. Meanwhile in Asia, the Japanese government unveiled details of a ¥5.5 trillion spending package in early December to mitigate the expected drag on the economy from an upcoming sales tax increase in 2014. This is on top of the Bank of Japan’s announcement last April to start an open-ended asset buying program that would double the monetary base 270 trillion yen ($2.9 trillion) by the end of 2014. The attempt is also a strong play on currency depreciation. Lowering its home currency (yen) increases the competitiveness of its primary economic engine; Japanese exporters. Unfortunately for the rest of the world, this also means that Japan is actually exporting deflation. The primary rationale for the glorious headlines of Japanese consumer price inflation of 1.2% in November was the yen’s rapid fall.While a weaker currency is a central aim of Abenomics, it is noteworthy that core inflation – which strips out movements in food and energy prices and is much less sensitive to the level of the yen – rose by 0.6% in the year to November. Deflation is a continued risk in Japan and also now in Europe and the United States.
Unless we see marked improvement in the Core PCE indicators throughout the world in early 2014, additional stimulus measures will be taken. In the U.S., this indicates that new Chairman Janet Yellen will be forced into additional tapering or more creative stimulus measures. Japan could easily suspend the upcoming tax hikes in an attempt to keep inflation inflated. In Europe, the ECB might even resort to the unpalatable bond buying program. The question at this point is will it even help. The U.S. public seems oblivious to the prospects of further declines in inflation. The Core PCE continues its descent while U.S. bank loan growth is unassuming. Stimulus measures initiated by our Federal Reserve are obviously not increasing total lending. After a debt binge of nearly twenty years in the U.S., there is nearly not enough end-demand for loans. Although businesses are borrowing at record low interest rates (many of the loans are used to pay off higher interest bonds), consumer have no desire to take on additional debt to spur economic growth.
The capital markets have largely disregarded deflationary risks for the past three years. Stocks have surged while bond yields have climbed. This is a true oddity. Government bond yields should be declining in a deflationary environment. It could happen in 2014 if the Core PCE indicator continues to decline. The truly scary proposition for the markets is if the economy would slide back into recession. At that point, we could easily see pure deflation as Japan has suffered previously. Japan’s currency depreciation war was made with an attempt to heal its own economy. But instead Abe’s policies might end up furthering the spread of deflation across the globe. One thing is for certain in 2014, the continual face off between deflation and worldwide central bank’s efforts to stop it should hit a head in the next few months. Deflation has been stealthily winning the battle so far, much to the unknowing public’s detriment.
Our firm has remained committed to our defensive position we took this past summer. This is due to a multiple of factors, including;
- Our favored Value Line index of 3-5 year appreciation for the average company is down to a record low of 30%. This indicator has not fallen to such low levels since 1999.
- For Q4 2013, 91 companies have issued negative earnings per share guidance. Only 12 firms have issued positive news.
- The trailing price/earnings ratio for the S&P 500 is now 18.72 versus 16.73 a year ago
- Investor sentiment is extremely low, with the Investors Intelligence bears chiming in at below 15%, near an all-time low.
- Mutual fund cash levels have fallen to trough levels, indicating all the cash is already in the market.
- Margin debt continues to climb, reaching over $400 billion in the most recent period.
- Insiders are not buying their own cooking. Only 17% of recent insider transactions have been purchases versus 27% last year and 35% three years ago. The average level since 1990 is 38%
- Many sectors such as healthcare and consumer discretionary are extremely overvalued on a historical basis.
In examining companies every day, we think the froth is very evident. With the market’s strong 25% plus gain this year, valuations are now among the highest in the past thirty years for nearly all the major sectors of the economy. We analyze large cap companies (above $7.5 billion market cap) on a monthly basis on a price/sales basis. We prefer price/sales ratio analysis as it moderates the impact of the economic cycle (i.e. price/earnings ratios in many industries collapse in a recession). Price/sales analysis also focuses us upon actual revenue growth for the company under question, as opposed to earnings manipulation through accounting mechanisms, share buybacks, etc. We examine the long-term history of the firm’s price/sales ratio vs. the current reading. We then breakdown the sectors into quadrants. The first quadrant lists companies with price/sales ratios that are in the lower quarter of all historical (15-year) readings. The fourth quadrant lists companies with high historical price/sales ratios. When we examine our lists, there is scant value in most sectors as we approach 2014.
Healthcare generally has been a favorite sector due to a strong historical performance combined with good defensive characteristics. We currently track 64 large cap companies within the space. This is the current valuation breakdown by quadrant;
Quadrant 1: 3 Companies (Teva, Merck, Fresenius)
Quadrant 2: 4 Companies (Pfizer, Quest, Baxter, GlaxoSmithKline)
Quadrant 3: 34 Companies
Quadrant 4: 23 Companies
A mere 7 firms out of 64 fall in the lower half of historical price/sales readings. In just examining the Vanguard Healthcare Fund’s return for the year ( up 40%), any astute investor can realize that stock prices have vastly outgunned revenue and earnings growth. Thus valuations within the sector have returned to levels not seen since the early 2000s. Many biotech firms such as Gilead, Biogen, and Celgene now trade at 40 times trailing earnings and at 6-7 times sales. These companies are extremely overvalued and the margin of safety for owning these stock is minimal. At the sector level, Healthcare is now trading at a 16.9 forward price/earnings level and on a price/sales ratio level of over 5. We were sanguine about the prospects for many companies a year ago including Roche, Zimmer, Becton Dickinson, and Merck. Today, only Merck provides for compelling value while Zimmer’s valuation is just above the median historical level. Roche’s shares have doubled in the past eighteen months, providing little in future appreciation potential.
This situation is not only witnessed within healthcare, but most other sectors. This includes the consumer discretionary, consumer staples, and industrial sectors. Other sectors are bifurcated, including financials, technology, and materials. For every Amazon in technology, there are undervalued gems like Altera. A few material/commodity firms stand out for strong undervaluation including Potash, Caterpillar, and Silver Wheaton. However, the overall number of securities trading at quadrant 1 type valuations as measured by price/sales ratios are very low. This leaves us with few opportunities to add new investment candidates within the equity markets. With corporate margins at record highs and sales growth anemic, the market is now priced for perfection. As Joseph P. Kennedy quipped in 1929, “Only a fool holds out for top dollar”.
Since our last monthly commentary “Everything’s Coming Up Roses” in early October, the market has continued to advance. More roses bloomed in Washington, as the impending doom of the debt ceiling was put on hold. It is an eternal summer for the roses theme, with not only Washington logjam on sabbatical, but also several of the negatives have been pushed to the sideline. This includes Bernanke’s tapering, which was to be finally put into place last month. Washington’s mess allowed Bernanke to punt the ball to the noted dove Janet Yellen. Now the tapering expectations have been pushed at least until January, if not extended until after the winter of 2014 has passed.
Other geopolitical events have also been placed on the back-burner. There looks to be no stomach to reboot the Syria issue as Obamacare is stealing the headlines. Iran looks to be coming around to our way of thinking, or at least maintaining an Oscar worthy performance in the repetitive movie “The Great Stonewall”. China has seemingly once again forestalled any potential real estate crisis by merely threatening to take in the liquidity.
Meanwhile in the U.S., companies within the Dow Jones Industrial Average (Dow) continue to pour out corporate earnings that are mixed at best. For every Boeing or Microsoft, there are plenty of catastrophes such as IBM, Goldman Sachs, and Unitedhealth. In fact, of the 30 Dow companies that have reported, I can count only seven that really demonstrated solid earnings growth (American Express, Boeing, Microsoft, GE, Johnson & Johnson, Pfizer, Travelers, and Nike). This explains the lack of breadth in the price action within the Dow. In examining the price levels of the 30 blue chip companies, only 10 have broken out to new price highs this month. That leaves 20 stocks that have not joined their brethren as the Dow Jones Industrial Average has reached a new all-time high.
I find it very hard to imagine all the heavy lifting that needs to be done to lift the Dow to substantial new price levels can be done with just a handful of stocks alone. Especially when many of the leading stocks within the Dow are trading at very high multiples of earnings. Boeing now trades at 24 times trailing earnings, Disney at 21, GE at 20, Johnson & Johnson at 20, 3M at 19, Nike at 25, and Visa at 25. The average multiple of earnings for the Dow is now 17.5 while the average dividend yield has dropped to just above 2% Both these numbers are above historical precedent.
All the good news has forced corporate insiders to the sidelines and pushed stock market bears into hibernation. Investors Intelligence survey readings now show those not sanguine on the markets at very low levels, 16.5% bears. As the Dow has climbed by 25% in the past twelve months, investors cannot seem to buy enough stock. Margin debt borrowed to purchase securities rose to a new record $398 billion last month on the NYSE. What is equally astounding is that this level is higher than the 2007 peak reading of $381 billion.
Keeping the discipline in a unrelenting bull stock market is difficult. But in stepping back, the list of worries about the market is much larger than the list of blessings. Although the Dow may climb another couple of hundred of points during the year-end euphoria, I feel the Dow is now demonstrating weakened breadth and is the most vulnerable to a sizeable correction.
“Everything’s Coming Up Roses” is a song from the 1959 Broadway musical a Gypsy, A Musical Fable. I am sure that market participants are today humming along and maintaining a small giddy-up in their step. Since my last market commentary, the S&P 500 index has advanced by just over 4%, including a 1.2% spurt yesterday alone. The advance has been based upon the “roses” theme as all worries have now been pushed to the sidelines.
What the markets expected 30 days ago;
- The future Chairman of the Board of Governors of the Federal Reserve System was going to certainly be Larry Summers.
- Assad’s use of chemical weapons would lead to certain U.S. involvement and lead to more chaos within the Middle East, dragging us into another potential war while oil prices surge.
- Mr. Bernanke would certainly taper in September, initiating the beginning of the end of the QE program.
Today the world is much different. The new consensus “rose coloured” view is;
- Chairman Bernanke has passed the torch officially to Janet Yellen. Ms. Yellen is considered potentially more dovish than Ben. There is a strong possibility that nothing will be done on the tapering front until she formally takes over in 2014.
- The Russians will certainly keep prolonging any potential U.S. act on Syria by stalling the chemical weapon destruction. Even in the case of a breakdown on negotiations regarding chemical weapon destruction, our Congress is in no mood to approve any strike.
- Interest rates have obviously peaked at 3% for the foreseeable future, especially with the Fed’s continued vigilance on keeping yields low.
Not only have the consensus “problems” been put on hold, but other economic concerns have gone unnoticed.
1. Earnings growth is sluggish and getting weaker;
- According to Factset, 104 companies in the index have issued earnings per share (EPS) guidance for the third quarter of 2013. Of these 104 companies, 85 have issued negative EPS guidance and a mere 19 have issued positive EPS guidance. The blended earnings growth rate for Q2 2013 is a mere 2.1%. 18 months ago the blended earnings growth rate ( Q1 2012) was a much stronger 6.1%. Thus growth in overall company earnings have continued to decelerate while the willingness to pay for those earnings has climbed. Due in part to negative EPS guidance, equity analysts have started to lower earnings expectations for the third quarter. The estimated earnings growth rate for Q3 2013 is 3.7%, down from an estimate of 6.5% at the start of the quarter (June 30)
2. Consumer sentiment is declining. Housing is weak;
- The Thomson Reuters/University of Michigan’s latest reading on the index of consumer sentiment fell to 76.8 in September, the lowest since April. That was a drop from August’s 82.1. Americans’ outlook is not much sunnier. A measure of consumer expectations fell to an eight-month low of 67.2 from 73.7 in August, with only one in four households expecting to be better off financially in the year ahead. Higher interest rates along with the headline news of Syria did not help. But although interest rates won’t soon breach 3% anytime soon, rates will not be returning to the 1.5% level reached this past April. Thus mortgage rates will remain close to current levels, which has already had a dramatic impact on housing. Refinance activity looks extremely difficult. It is down 55 percent from one year ago and should remain tepid given 10-year rates are still 2.75%. Lawrence Yun, Chief Economist and Senior Vice President of Research at the National Association of Realtors recently commented “Refinance activity could easily fall to a 15-year low in 2014″.
3. Equity Valuations are higher than 12 months ago;
- The S&P 500 is now in record territory. The advance has primarily (2/3) been through price/earnings multiple expansion. The current 12-month forward P/E ratio is now 14.6 , based upon consensus expectations of $118 in earnings over the ensuing 4 quarters. This is up from the 12 times forward earnings the market traded at last September. Other valuation methodologies do not provide much support to the market’s current price level, including the Tobin Q and the Schiller P/E model. Value Line’s average appreciation potential of stocks has collapsed down to 35%, the lowest figure since 2007. The figure also is within the lowest 5% of all readings since Value Line began in 1966.
4. The technical underpinnings of the market are not as strong as perceived;
- New 52 week price highs have actually not confirmed the rally. There were 326 new highs on the NYSE during yesterday’s advance. This is still below the May levels. In addition, the percentage of NYSE stocks above their 200-day moving averages is also continuing to demonstrate weakness, confirming the 52-week high divergence. Meanwhile, sentiment on the market shows investor complacency. The equity put/call volume ratio has gone below the level of .55, considerably lower than last year’s.85. In fact the ratio has now entered its “bullish” extreme levels last seen in early 2011. The Rydex Nova/Ursa fund ratio has also broken to a 3 to 1 extreme. This indicates investors in September have jumped into the bull fund versus the bear fund by a significant margin.
Due to the rosy outlook from market participants and the declining earnings growth statistics, I continue to feel as the risks to the market are on the downside over the next six months. Any alteration to the perceived timetable to initiating tapering (now 2014) would now startle the market. Furthermore, Janet Yellen’s confirmation is not a given. She may also not turn out to be the dove everyone expects (see Justice Roberts). I suspect the Syria situation, although delayed, could once again enter the nightly headlines as frustration grows with the promised destruction of chemical weapons. A reversal of supposed economic recuperation in Europe and/or China could be easily undone during the fourth quarter. Lastly, a potential debt ceiling standoff could offer another risk element the market is now fully ignoring.
The stock market is looking stretched in my view, with several key indicators demonstrating caution. This includes the sub-par earnings growth, higher stock valuations based on forward earnings, higher interest rates, and breadth statistics.
The stock market (S&P 500) has advanced by 30% since June 4th, 2012. During this period, earnings have accounted for approximately 1/3 of the gains, with Price/Earnings expansion accounting for 2/3. This is not suprising as earnings gains have slowed in each subsequent quarter over this period. According to Factset, 464 companies that have reported earnings to date for Q2 2013. Of those 464 firms, 72% have reported earnings above the mean estimate. But the blended earnings growth rate for Q2 2013 is a mere 2.1%. If this is the final growth rate for the quarter, it will mark the third consecutive quarter of earnings growth for the index that has contracted.
A year ago, the blended earnings growth rate for Q1 2012 was a much higher 6.1%. Thus growth in overall company earnings has had a large drop in the preceding 12 months while the market has continued to march higher. Additionally, the current 12-month forward P/E ratio is now 14.2 versus a 12-Month forward P/E ratio of 12.0 when this rally ensued last June. The current forward P/E ratio is now slightly above the 10-year average of 14.1 Although the overall valuation is not demanding at current levels versus history, the forward valuation has increased by nearly 20%. The absolute question is how can the market advance through further multiple expansion when earnings growth is falling? I don’t think it can. In fact, I feel the forward valuation should most likely contract over the next 12 months.
Rising interest rates are another strong headwind for stocks. Bonds serve as a competitor for stocks. As yields rise, investors will be more attracted to debt instruments. Secondly, the U.S. economy has been spurred dramatically by lower interest rates, through low mortgage and car financing. Higher rates will no doubt put restraint on this growth. An investor need only look at the price action of the iShares Dow Jones US Real Estate (IYR) exchange traded fund. At a new price low of $62.05 reached this morning, the IYR has now dropped by 18.5% since May 22nd. The strong negative price action in the IYR real estate fund indicates that the housing market will be soon seeing a drop in demand as higher rates bite the U.S. consumer.
In regard to the technical indicators, not all is well as the market has broached the 1700 level on the S&P 500. New 52 week highs have actually fallen during this latest advance. Although the advance-decline lines are confirming the new highs for the S&P 500, new 52-week highs have contracted, causing a negative divergence. The percentage of NYSE stocks above their 200-day moving averages is also demonstrating weakness, confirming the 52-week high divergence. Meanwhile, sentiment on the market drop from 1700 shows investor complacency. The 5-day put/call ratio recently reached the lowest level since mid-September 2012. This was a just before the fall market correction that took the S&P 500 down 8% in a period of five weeks.
Due to these economic and technical factors, we feel the market has settled into a correction phase. We remain above weight in cash in our stock portfolios and are maintaining a defensive position in our asset allocation composites.
Timothy McIntosh, CIO