It is time to take a big picture look at everything: This is a summation of everything we have discussed over the past month and quarter. Where are we in this particular cycle?
Macro-Economy: The economic backdrop seems to be confusing quite a few people. Perhaps its the psychology of the moment. I keep hearing weak, data free analysis. Here is our 7 point overview:
1. The Economy is recovering; The recession is over: Of that, we have no doubt, as the data is clear. The free fall of 2008-09 is over, and a gradual improvement is seen across the board. Industrial manufacturing, exports, autos, retail sales, durable goods, travel all confirm that the economy is “healing.”
2. But, the recovery is “Lumpy”: — Part of the reason some people doubt the recovery story is how unevenly distributed the improvements are. Geographically, much of the country is still soft. In retail, it is pent up demand plus luxury goods. In technology, it is mobile devices and consumer products. Financial firms are taking advantage of the steep yield curve and ZIRP to arbitrage profits, as opposed to actually lending. Profits are not evenly distributed either.
3. Government spending is only part of the story: In the midst of the crisis, Credit froze, the consumer panicked, and business spending looked to be going extinct. Uncle Sam temporarily bridged the gap.
But the argument that government spending is the only game in town overstates the case. Private sector CapEx spending and hiring is improving (albeit slowly); Consumers have come out of their bunkers and are dining out, going to the movies, hitting the malls, and traveling.
We have not returned to the Home ATM days of 2004-07 — and probably won’t in our lifetimes — but the present environment is a massive improvement from the 2008-09 contraction.
4. Weak Improvement in Employment: The massive labor under-utilization is one of the two biggest drags on the economy (RE being the other). Near record low hours worked suggest that employers can simply increase hours rather than make new hires. Thus, I do not look for a V-shaped employment recovery — forget about 400-500k NFP data — anytime soon.
There are 15 million unemployed, and 8 million underemployed — it will take a long time for them to be re-absorbed into the economy. The 2001 recession took 47 months to return employment to pre-recession levels. This recession will likely take 65-75 months to achieve that goal — if not longer.
5. Real Estate (Commercial and Residential): We do not believe that residential real estate has found its natural price level yet. It remains over-valued. This is due to artificially low mortgage rates, foreclosure abatements and mortgage mod programs. We are probably 10-15% over valued, when measured by Median Sales price to median Income, Rent vs Ownership Costs, and Home Value as a Percentage of GDP.
Commercial real estate tends to lag residential by 18-24 months. It is still adapting to the downsizing of America, particularly retail. The over-investment in commercial real estate of the past decade will take at least another 5 years to resolve, if not longer.
6. Deflation? Inflation?: Well, as my pal Jeff Saut notes, we definitely have “flation.” Just not the type that everyone fears.
As of today, Deflation is a fact, inflation is an opinion. We are still living in a period of falling prices, heavy discounts, wage deflation, asset depreciation and lack of pricing power. The S&P500 is below levels seen in the 1990s; Wages are flat for a decade.
The risk going forward is that the Fed fails to remove the accommodations in time. But they have Japan as an example of ZIRP with no inflation. So long as labor under-utilization is near record levels, they can take their time in tightening.
7. The rest of the world: Europe is a disaster, and is likely to remain that way for a while. Asian economies are doing very well, helping to pull the rest of the world along — but China’s market is at 6 month lows, something few people are discussing. The risk in China’s real estate and stock markets has been mostly ignored,. Commodity regions and emerging markets still have strength.
Market Overview: Unfortunately, most of the commentary we see about markets has been unusually ignorant, myth driven, and based on rationalizing bad decision making.
1. Cyclical Bull, Secular Bear: The secular bear market collapse of 55% was right in line with other such debacles. The collapse was faster and more furious than typical, but the depth was normal. The snapback is also well within the range of bear market rallies — cyclical bull runs that last 6 to 24 months and range from 25% to 135%.
While it is possible that we are witnessing the start of a new 1982-like Secular bull market, the valuations argue against it. Stocks most likely simply did not get cheap enough — or despised enough — to initiate a multi-decade bull run. My best guess about that bottom is its likely 3-7 years away.
2. Snapback: The 75% bounce over a year seems like a lot — until you put it into the context of a six month 5,000 point collapse. we call that the Armageddon trade — Dow 5000! 3000! We’re going to zero! — was a spasm of panic. It has been mostly unwound this past year.
3. Correction coming (eventually): The cyclical bull tends to end with ~25% correction that lasts about a year. So we are always looking for signs that this run is over. Despite the recent turmoil, we have not found confirmation that the bull run is over — yet.
We look at many factors to help identify that inflection point:
4. Liquidity: Institutional fund managers seem to be all in (only 3% cash), while Investors are at only median levels of equity exposure. Liquidity is still abundant, free money abides. Money flows for the past few months have gone into US equities — that is a new element — at about $2B per week.
5. Internals: The market technical/internals remain constructive: Breadth and momentum are positive. New 52 week highs are also strong. Earnings are supporting some of the move, as year over year comparos are absurdly easy. The uptrend remains in place, and until it is broken we maintain an upside bias.
6. Sentiment: The biggest risk is the unusually high level of bulls. Note however that even that has moderated over the past week. We are not at the sorts of extremes yet that make the contrarian in us scream SELL.
Next week, we’ll look at Macro Overview: Investing & Psychology