US Stock Market: Bulls vs. Bears; Historians vs. Risk Takers?
October 17, 2011
David R. Kotok
“The jury is still out.” That legal term has been a headline for two centuries. In the 1940s, its usage morphed to a broader reference factual findings of all types. We will apply it to the stock market today.
The jury is still out but the evidence keeps coming in.
For the last several months, we posited that the August 8 bottom of the S&P 500 Index at the 1100 level was a robust selling climax. Whether it was an interim selling climax or a final selling climax is unresolved. That jury is still out.
The selling commenced at the beginning of May. It accelerated sharply to the down side at the end of July and into early August. The reasons that caused the sell-off are history now, and discussion of them is redundant.
We have written on several occasions that the 1100 level was established with intraday trading on August 8, tested twice in the futures market and held. In the subsequent rally and sell-off, the 1100 level was pierced on only one day. The 1100 S&P level has continued to hold and reflect a tentative bear market bottom. The most recent test that successfully reaffirmed this bottoming level of the S&P 500 Index occurred on October 3. Markets have rallied strongly since. The S&P 500 index is about 1228 in Asian futures market pricing this morning.
Many of our internal studies indicate that the potential for an upward move in stock prices is huge. We are positioning accordingly and have been since the sell off intensified in July. We have established this position s risk takers, not as history book writers.
On the other hand, there are conflicting and negative forecasts that argue the opposite of Cumberland Advisors’ position. The negative forecasts are usually coupled with recession forecasts. Readers see them every day on TV, hear them on radio and read them in the financial press. Harsh and negative forecasts dominate the media.
Meanwhile, the economic evidence is mixed. It does not support the recession scenario. The US economy is not shrinking. The economy continues to muddle along at a slow growth rate. There is no strongly robust, apparently upward, trend. There probably will not be one for several more years. Slow growth centered on 2% is more likely to be the norm.
Fears of a financial market meltdown or a repeat of Lehman Brothers/ AIG failures of 2008 continue. Very negative pictures can be painted on the outcomes of the European sovereign debt crisis. Other negatives can point to more deteriorating factors in the United States, such as the weak housing market and the high unemployment rate.
In our view, all of these factors are known. They have been established for some time. They have been mixed into the pricing expectations in markets. In essence, they are “old news”.
As investment risk takers, we believe the August 8 climax at 1100 level was a final climax. That determination is the basis for our investment posture. The climax is/was enough for us to take a position on markets. It is not enough for us to write a history book chapter. For historians, a candid assessment of the outcomes would suggest that there is no sure way anyone can know now. At the very least it was a robust interim climax and set the stage for the strengthening stock market that has occurred since.
For historians, it remains to be seen if the 1100 level was the final selling climax low in a market that peaked on April 29, sold down in August, retested the low in October, and is firmly in an uptrend. Historians will not know that until the market is much higher and more time has passed. Note that here is an important difference between investment risk takers and history book writers.
Historical studies suggest that there are two possible scenarios at work. At this point in time they would look alike so either one is possible.
History says that if there is a serious, prolonged recession in the next year or so, then it is likely that we witnessed only an interim selling climax on August 8. That means there is another leg down in stock prices ahead of us. That is the bear case promoted by numerous money managers and advisory firms who forecast an S&P 500 Index level of somewhere between 800 and 900 as a bottom.
That is not the perspective at Cumberland. We support a second scenario.
That history says there may not be a second leg down recession. Instead it calls for a slow but steady rate of growth centered on 2% in real terms. It will be accompanied by low rates of inflation and very low interest rates. This is likely to be in place for the next couple of years. This means the profit share to business will remain very high, and it means there will be a slow but steady growth rate of nominal GDP. From this rising nominal GDP, the earnings for American business are likely to stay high and continue to rise.
Furthermore, there is some evidence that the housing market is bottoming in some regions. This data is also mixed. However, there are gradual signs that a base is being formed in some housing sectors. The result of that is to ease the pressures on the banking system, and indicate that the credit problems attached to the housing debacle may begin to subside.
If this is so, and we believe it is, then the financial stocks, which have been devastated for four years, are currently positioned for a buying opportunity. In Cumberland’s case, we have scaled into financials several times and taken up the weights in the regional banks. So far, that is proving the correct course of action. We have taken the overall financials exposure above market weight. We continue to be a scaled buyer in financials.
For an excellent discussion of the banking sector, see Andrew Bary’s column in Barron’s this weekend. For superb detailed discussion about banks see Dick Bove’s research at Rochdale Securities. Additional excellent discussion is found in Jason Benderly’s proprietary work on the financials and markets.
Ten days ago, the entire banking system of the United States was for sale below its stated book value. One could argue it was for sale below its tangible book value, which means you could buy all the banks in the United States at stock exchange prices trading for less than their liquidation value. Clearly, that is an absurd pricing level.
Are banks now sound? Answer: some are, some are not. Are there still problems ahead in the financials and in the banking sector? Obviously, yes. Is regulatory change an issue? Again, yes. Are earnings derived from net interest margin an issue? Once again, yes. Does that mean that banks are dead forever? Our answer is a resounding no.
The time to enter a sector and start to take up the weights is when it has been devastated in a bear market for several years and priced to an extreme. When you price the entire banking sector below its liquidation value, below its tangible book value, you are seeing a pricing level in a climate where all the bad news is known or identified. Only then are you are defining an entry point. Further, the financial sector has lost ten percentage points of the value share of the stock market since its peak. Think about this sector where it once was 24% of the market weight and derived 40% of the market’s earnings. Now it is 14% of the market weight. Its earnings are substantially down from the peak earnings that were extant five years ago when everyone wanted to own financials.
In summary, we do not know for sure if the 1100 level on the S&P 500 Index was a final selling climax established level or is an interim selling climax level. It will take more time to write that history book chapter. We are basing our investment risk taking action on the likelihood it was a final climax. It will take months before that finding is firmly established.
We do know that, at least, we did have a robust interim selling climax. The 1100 level was tested several times and has demonstrated support. We do know that buyers are tepidly coming into stocks. There is a large amount – trillions of un-invested funds – that face decisions about whether to nibble at the stock market or stay in the bond market or cash equivalents at very, very low interest rates. In our view, the US stock market is currently a place of opportunity. We are in it.
Cumberland’s US exchange-traded fund accounts continue to be fully invested in diversified ETF portfolios. We are increasingly emphasizing growth-oriented ETFs at this time, and mixing the weights and sectors accordingly. We are gradually taking up exposure to the financial sector. We are targeting an S&P 500 Index level of 1350-1400 based on a high profit share derived from a GDP above $15 trillion. We expect that nominal GDP to rise at about a 4% annual rate or higher for the rest of this decade. We project that the GDP will reach $20 trillion by this decade’s end. Our longer-term target for the US stock market is the 2000 level or higher. If the GDP profit share rises to the level we saw in the 1950s, that stock market outcome could be much higher.
David R. Kotok, Chairman and Chief Investment Officer
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