Can Chanting “Accelerating Growth” Long and Hard Enough Make GDP Grow Faster??

Phil Davis has a great post this morning (07.23.14) where he discusses the financial media’s distorted reporting of GDP growth in the US and around the world. He specifically cites a Bloomberg article that references “accelerating growth.” Let’s look at a couple of graphs and watch as GDP growth accelerates. First graph below shows quarterly GDP growth in Japan, the UK, Germany and the US since the 4th quarter of 2009.

Quarterly-GDP-GrowthDoes everyone see which country is driving the “acceleration?” Yep — Japan and its Godzilla-size QE experiment. Next let’s take a look at the weighted average growth rate of the 4 countries (the US consistently accounts for 60% of the total GDP of all 4 countries). Japan’s 1-quarter bolus to the “acceleration” of GDP growth has lifted the average all the way to a spectacular . . . 1.4%. (Yes, the rates are annualized.)


Let’s add a trendline to the above graph and have another look:


Adding to Phil’s point: if the trendline points downwards, but the financial media calls it accelerating, then it must be so. Dissent at your own peril.

Categories: Market Commentary

Markets in “Risk-Off” Mode for First Half of 2014: Utilities and Large-Cap Stocks Lead as Interest Rates Decline

As we begin the second half of 2014, let’s take a look back at how equities and interest rates performed in the first half of the year. The first chart shows that U.S. large-cap stocks (the S&P 500) posted strong gains of about 7% in the first half, but small caps (the Russell 2000) lagged with a total return of just under 4%.

SP500-Russell2000When large-caps lead small-caps we usually think the market is in a bit of a “risk-off” mode, which is confirmed by the gradual decline in the 10-year Treasury note yield, shown in the chart below. Despite the chants of “great rotation” from the financial media, the long-predicted rise in interest rates has not yet materialized.

US-T-Note-YieldGrowth stocks edged out value stocks with total returns of 7.37% vs. 7.00%:

Growth-vs-ValueUtilities led the way as investors reached for yield, with Energy and Materials stocks posting strong gains, most likely in anticipation of the highly-touted expected increase in inflation that has also failed to materialize:

Best-SectorsConsumer Discretionary stocks lagged along with other “risk-on” sectors like Financials and Industrials:

Worst-SectorsOverall, investors were handsomely rewarded in the first half of 2014, considering that U.S. stocks rose 30% in 2013. But the market’s internals are weakening, as investors repositioned to play defense in the second half of the year. Now that former doves like the St. Louis Fed’s Jim Bullard are arguing for the Fed to exit markets sooner rather than later, expect an immediate increase in volatility at the first sign that the Fed is actually backing off. But it’s important to note that thus far the Fed has only talked about accelerating the taper. As pointed out by Phil Davis today, the Fed continues timing its cash injections to aid end-of-quarter window dressing. What would stock values look like in a market that was not supported by the Fed? It’s been a long time since we’ve had an answer to that question — so long that many have probably forgotten the concept altogether.

[Data from S&P’s Capital IQ]

Categories: Market Commentary

U.S. Stocks May Not Be Overdue For A Correction After All

Five years of persistently slow growth and a sluggish labor market, increasing global instability and a new Fed Chair that openly contradicts herself — U.S. stocks seem to be able to shrug off any sort of news as long as there’s Fed stimulus to be had. Investors who have anticipated a correction in this “teflon market,” where bad news doesn’t stick, have been thwarted short squeeze by short squeeze. The latest argument for a market decline has been that we are overdue for a correction (a decline of 10% or more). Let’s take a look at the history of corrections by decade, from 1945-2014, and see just how overdue we might be.

The table below shows the percentage of overlapping periods when the month-end level of the S&P 500 has been at least 10% lower than the end-of-month level 1, 3, 6 and 12 months prior. Above-average frequencies are bold and shaded, with below-average frequencies in red.


The data show that decades characterized by an above-average frequency of corrections are reliably followed by approximately two decades of complacency, featuring a sharp decrease in the frequency of corrections.

Therefore, while it may feel as if stocks are overdue for a correction, it is not uncommon for stocks to remain in bull mode without correcting following a decade of volatility and low returns, such as the 1970s and 2000s. Stock values may correct for any of the usual reasons, such as an information shock or overvaluation concerns, but not for the simple reason that a correction is overdue. Thus far the 2010s are playing out similarly to the 1950-1969 and 1980-1999 periods in terms of having a below-average frequency of stock market corrections.

Categories: Market Commentary

Stock Market Overvaluation Explained in One Chart

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.” — Upton Sinclair

Market pundits seem to have the most difficult time embracing the concept of overvaluation. This morning on CNBC, Art Hogan once again demonstrated how to dance around the issue when he stated:

“What’s actually happening in the marketplace is, like it or not, the movement in the market mirrors almost exactly the move in earnings growth,” Hogan said. “If you look at how much the markets have gone up on a percentage basis, [earnings and the market are] almost identical or within a percentage point or two of each other.”

The following graph shows that Hogan is correct — the stock market and earnings have indeed grown at a similar rate since March 2009. However . . .


. . . the problem is that stock values since 1982 have increased 1600%, while earnings have grown about 600%.

Hogan focuses on one slice of the data — starting from an artificially-depressed bottom in earnings in March 2009 — and matches up the growth rates in the two series over the last cyclical bull cycle. Over the entire secular bull/bear cycle, however (1982-2013), stock values have appreciated at almost three times the rate of earnings growth.

Hogan tries to cram a secular, multi-decade bull/bear story into one cyclical bull market cycle, with the net effect of conflating the bull/bear/overvaluation debate. Just as he is paid to do.

Bottom line is the market will not correct until the final two indicators flash — when Ed Yardeni and Abby Joseph Cohen are trotted out to revive the “coordinated global boom” meme they pushed all the way up to the 2008 financial crisis — then you’ll know it’s time to run for the exits.

Categories: Market Commentary

Is the U.S. Economy Growing or Not?

The recent revision to Q1 real GDP growth, all the way down to a dismal -0.6%, has sparked a debate in the financial media that is somewhere between wild and desperate. CNBC trotted out the usual cast of “experts,” some pontificating that negative GDP growth “didn’t matter,” with others proclaiming that negative GDP growth represented truly good news, as economic activity for the rest of the year was poised to rebound (reminiscent of Liz Ann Sonders’ “coiled spring” hypothesis, which she hyped steadily from 2009 to 2012, before finally letting the meme drop). And just this week, Charles Hugh Smith posted an elegant diatribe (Our “Make it Look Good” Economy Has Failed) in which he claims that the numbers used to portray economic activity have been massaged into a positive narrative that is completely disconnected from reality.

In this post I will provide graphs of the long-term trend in several key economic indicators (most of which are included in The Conference Board’s leading or coincident economic indexes) and let readers answer the key question for themselves: “Is the U.S. economy growing or not?”

Let’s start with the biggie, growth in real GDP. The graph below shows that growth has been trending inarguably lower since the late 1990s.


Next is nominal and real Durable Goods orders. If the following graph were a stock chart, we would immediately recognize a classic “triple top” formation. (The resemblance to the S&P 500 is also clear.) We have achieved the same level of Durable Goods orders as in 2000 and 2008 — with both previous tops immediately preceding recessions!


Next we’ll look at real and nominal Capital Goods orders, ex-aircraft to smooth out unusual one-time data points. The real series is in a protracted bear market — not only is the series not growing, it’s clearly shrinking. Capital Goods orders have failed to keep up with inflation (which is negligible, given all the deflationary fears permeating the environment).


How about New Building Permits for Private Housing? After all, we’re allegedly in a housing boom, are we not? If your definition of “boom” is when builders pull the same level of permits as during the depths of the 1982 and 1991 recessions, then I guess we’re in a boom.


Overall, it’s hard to miss Charles Hugh Smith’s point: the trends in these key economic variables are anemic, and bordering on pathetic. Yet, every day now, “the same Broadway kick-line of dancing clowns” (in John Hussman’s words) that told us credit risk was contained in 2008 are telling us that all the numbers are pointing toward sustained economic recovery.

All of this makes me nostalgic for the days of relatively harmless memes, like “ketchup is a vegetable.” Now, before you scoff, did you know that the king of condiments was officially classified as a vegetable by a 2011 Senate bill? Maybe all we need is for Congress to pass a law declaring that negative GDP growth is officially good news, and we can all stop worrying.

Categories: Market Commentary

Gentlemen, Start Your Hedges: “Hedge in May” Option Strategies

Permabull David Tepper of Appaloosa Management spooked investors at this year’s SALT Conference with his “I am nervous, I think it’s nervous time” pronouncement (read more at Zero Hedge or Business Insider). One year ago Tepper gained credibility with his prescient warning that short sellers were “digging their own graves,” as all the major stock market indexes continued rising for the rest of 2013. Now that Tepper is signaling something between caution and bearishness, suggesting that Central Banks have contributed to a mindset of “coordinated complacency,” it looks like a good time to review some hedging strategies for the downside-minded among us (I’ll use pre-open charts and prices from May 15 2014).

Adding to investors’ nervousness is the disconnect between small-cap stocks (measured as the Russell 2000 index), which are struggling to find support at their 200-day moving average:


and the S&P 500, which has found consistent support at its 50-day moving average:


If you’re interested in speculating on a mild May correction, you might consider a bear put spread. Below I’ve graphed the payout from buying 1 Sept. SPY 190 put ($6.92) and financing most of that position by simultaneously selling 1 Sept. SPY 187 put ($5.62). The position costs $1.30 net, and pays off a maximum $1.70 if the SPY declines by 1.5% or more).


For those of us who are only short-term bearish and interested in hedging a long equity portfolio, buying the Sept. 187 put for $5.62 provides a little portfolio insurance, as shown below. Based on a May 14 closing price of $188.75 for the SPY, this position caps your losses at -3.9%, including the cost of the put option.


And, for those who think a market decline much larger than -3.9% is likely, simply buying the Sept. 187 put allows for a more aggressive downside bet:


I recommend watching the Friday closing action closely — it will be interesting to see the extent to which traders will feel comfortable staying long over the weekend. A weak final trading hour on Friday would add to the market’s nervousness.

Categories: Market Commentary

Apple vs. Amazon: A Tale of Two Tech Stocks

U.S. stocks have displayed substantial volatility thus far in 2014, but gained little ground overall following 2013’s spectacular returns. When stocks churn up and down but fail to establish a definite direction, analysts will sometimes say prices are “consolidating,” or “stuck in a trading range.”

But that does not mean that the prices of individual stocks all follow the same directionless pattern. The chart below shows the percentage change in the prices of two popular technology stocks, Apple and Amazon, from early January to late April 2014.


While both stocks started the year with losses, declining by 10% (Apple) and 13% (Amazon) by late January, Apple went on to earn a positive return (+4%), while Amazon’s stock has continued to slide, accumulating losses of almost 24% over the same period. The two companies’ very different reactions to their recent earnings announcements in late April can be seen in the chart — Apple’s stock gained almost 8% in one day, while Amazon’s declined by almost the same amount. What caused these two tech giants to have such different returns thus far in 2014?

The answer has to do with the ability to grow profits and earn a sufficient return on the capital invested in each company, usually referred to as a company’s “fundamentals.” The next graph compares each stock’s gross profit margin, which measures the percentage of sales revenue left over after covering basic costs. The companies look competitive, with Amazon gradually expanding its gross margin.


But when we progress a little further down the income statement and compare each stock’s operating profit margin, which takes a more complete range of expenses into account, a different picture emerges:


Apple posts a consistently positive operating margin that fluctuates between 25-35%, while Amazon’s starts out low (below 5%) and deteriorates further, all the way down to 1% for fiscal year 2013. Worse still, Amazon has pre-warned the market that it is likely to lose money in the 2nd and 3rd quarters of 2014, with the possibility of even further deterioration in its operating margin. The market clearly disapproves of this trend, and has reacted by punishing Amazon’s stock price.

The next graph compares Apple and Amazon based on their return on invested capital (ROIC), which measures the change in value of each dollar invested in the companies over a full fiscal year. In order for a company to grow its value, its ROIC must be greater than its cost of capital, or the minimum return demanded by investors each year. While the cost of capital can vary widely, from as low as 5% (for the safest companies) to as high as 12% (for the riskiest companies), the return on capital must always be above the cost of capital, or the company is decreasing the value of investors’ capital.


When it comes to return on invested capital, Apple is amazing — it has been increasing the value of investors’ capital for years. While Amazon earned a healthy ROIC in 2009 and 2010, their ROIC has evaporated in recent years, even turning negative in 2012. And, based on Amazon’s recent announcements, investors can expect continued substandard performance from the company for at least several more years.

Therefore, although the brand names “Apple” and “Amazon” evoke similar admiration among consumers, when we “open up the hood” and view the companies from the perspective of an investor, we quickly see that we are dealing with two completely different cases. Apple is not only an exemplary brand, but a strong and profitable company. Amazon, on the other hand, is suffering through some major growing pains as it tries to wean consumers away from the deep-discount/free shipping mentality that is the root cause of the company’s lack of profitability. Based on the dramatic declines in its stock price so far this year, the market apparently remains unconvinced that Amazon will be immediately successful at restoring its profitability to acceptable levels.

[Data supplied by S&P’s Capital IQ. The author holds no positions in AAPL or AMZN at the current time.]

Categories: Market Commentary

Get Real: 2013 was Another Sluggish Year for GDP Growth

The last 4 years have been characterized by a consistent phenomenon among economic forecasters: each year began with forecasts of strong consensus growth ranging from 3.0-4.0%. As each year 2010-2013 unfolded, however, these forecasts were gradually ratcheted down until the final, disappointingly-low revised number was quietly revealed. Despite all the go-go forecasts, 2013’s final growth rate settled down to a lackluster 1.9% — the average since 2000. The chart below shows the annualized growth rate of real GDP (trailing 4 quarters) since 1948.


The 30-year trend of slowing growth is evident in the graph. Average growth has fallen every decade since 1981. Since 2000, Real GDP growth has averaged only 1.9% per year. Despite reduced tax rates, staggering budget deficits, artificially low interest rates and multi-trillion dollar stimulus programs, this is all the growth the US economy has been able to muster.

Until economists set aside their “magical thinking” and start discussing the economy in which we’re operating, rather than the economy they wish we had, we’ll continue overdosing on the wrong medicine. To read more on how our collective thinking can become so highly focused on the wrong issues, refer to my 2009 article The Dogma Days of Summer.

Categories: Market Commentary

Sector Returns Q1 2014: Utilities and Health Care Led the Way

One of my favorite ways to gauge market sentiment is to study which sectors led the way over the past quarter (I use the returns to the SPDR sector ETFs — data obtained from S&P’s Capital IQ). For the all-important first quarter of the year, comparing sector returns can also signal what type of a year it will be for stocks. The first chart shows that two distinctly risk-off sectors, Utilities and Health Care, had the best returns for Q1, with 10.9% and 6.1% total returns, respectively.


The middle of the pack sectors were Telecom (3.8%), Materials (3.1%), Financials (2.7%) and Technology (2.7%). These sectors delivered respectable returns, but suggest a more cautious outlook for 2014. If investors were more bullish, we would expect sectors such as these to outperform the safer Utilities and Health Care sectors.


Bringing up the rear we have Energy (2.1%), Consumer Staples (1.6%), Industrials (1.6%) and Consumer Discretionary (-2.7%). The weak performance of the risk-on sectors (Energy, Industrials and Consumer Discretionary) reinforces the impression that investors waded into stocks cautiously in Q1 2014.


A sluggish first quarter for stocks is not that concerning, given the 30% returns we saw in 2013. A quarter of consolidation is certainly warranted. If the risk-on sectors don’t play a bit of catch-up in April-May, however, especially Consumer Discretionary, Industrials and Energy, we may be in for yet another “sell in May and go away” range-bound summer. Stay tuned.

Categories: Market Commentary

S&P 500 Forms Ominous Technical Pattern

[02.16.14] I look forward to fund manager John Hussman’s blog posts each week ( John is an experienced market researcher, but in some of his articles last year he reflected on his overvaluation concerns, which were similar to those expressed by Jeremy Grantham’s team (read GMO’s November 2013 newsletter here regarding asset overvaluation in 2013).

Hussman’s February 17 post contains some dramatic updates to his long-term market thesis that I will review below, and then comment on further. I recommend reading John’s full article: Topping Patterns and the Genuine Cause for Optimism. (First 6 exhibits that follow are from Hussman’s Feb. 17 article.)

First, John reproduces a graph he’s been updating frequently, using a methodology from Didier Sornette’s Why Stock Markets Crash:

Log-Periodic-BubbleThe graph shows the S&P 500 converging on what Sornette terms a “log-periodic bubble,” which is essentially caused by investors “buying the dips” reflexively every time the stock market declines in value. “Buy the dips” results in corrections that are shorter and shallower each time. This pattern has prevailed immediately before each of the most serious historical stock market bubbles burst (1929, 1973 and 2000) — the fact that it’s repeating again in early 2014 is mildly nerve-wracking.

Next Hussman explains a technical pattern known as “3 peaks and a domed house,” attributed to George Lindsay’s Art of Technical Analysis, which was edited and updated by George Carlson in 2011. The pattern is shown below — Hussman asserts that we are most likely at point 27 in the pattern — the one just before a market crashes:

3-Peaks-Domed-HouseThe similarities with 1929’s point 27 (S&P 500):

3-Peaks-19291973’s point 27 (S&P 500):

3-Peaks-19732000’s point 27 (Dow Jones Industrial Average):

3-Peaks-2000and 2014’s point 27 (S&P 500) are impossible to miss:

3-Peaks-2014Considered along with the Sornette log-periodic bubble analysis, I would say this additional perspective takes us into moderately nerve-wracking territory — especially after a 5-year bull market run that’s raised equity values 135% above the March 2009 lows.

The Shiller P/E10 (or “CAPE,” for cyclically-adjusted P/E ratio), is one of the most popular metrics analysts cite as signaling overvaluation. Some analysts have questioned if the P/E10 is as relevant as it once was, however. (This article by Chris Turner via Advisor Perspectives explains how analysts use the P/E10 to estimate the fair value of the S&P 500.)

I have written several articles on how the P/E10 forecasts long-term stock returns (including The Journal of Portfolio Management, June 2007). Below I’ve updated the exhibits from a 2012 article I published in Problems and Perspectives in Management, entitled Could US Stocks be Fairly-Valued Under the “New Normal” Paradigm? The graph shows that, as of year-end 2013, US stocks were overvalued based on historical values of the P/E10, but only by as much as 8.6% if investors are benchmarking “normal” to the post-1982 period (the start of the last secular bull market):

SP500-Fair-Value-PE10On the other hand, if the market’s memory is shorter, and investors benchmark fair value to a P/E multiple based on only a 3-year moving average, and use an exponential moving average of past earnings that places more weight on recent observations (which I call the P/EXP3):

SP500-Fair-Value-PEXP3US stocks could have been undervalued as of year-end 2013 by as much as 6.8%, if, once again, investors are benchmarking “normal” to the post-1982 period.

Conclusion: Both a Sornette log-period bubble and a Lindsay “3 peaks and a domed house” formation are evident in US equity values in late 2013 through early 2014. These patterns have preceded the bursting of stock market bubbles in 1929, 1973 and 2000. Additionally, US stocks are “overvalued” based on a traditional P/E10 CAPE, but are within the high range of normal valuation if the market no longer benchmarks to a 10-year moving average of earnings and/or a 130-year history of relative valuation.

Consistent with a large body of research (Shiller’s Irrational Exuberance included), it’s extremely difficult — and perhaps impossible — to see a bubble through the windshield. Only after the bubble bursts, and we can study it in the rear-view mirror, can we rationally deconstruct how we got there and why we couldn’t back away from the precipice with sufficient caution not to burst the bubble. I see current circumstances as another of these instances. Investor enthusiasm for “buying the dips” makes it difficult to forecast the imminent bursting of a bubble, unless there are further negative developments in the unfolding global credit market downturn. I would recommend assuming a strongly defensive position only if global volatility increases significantly. This week’s news flow bears close watching.

Categories: Market Commentary