April 30, 2012
Release the Kraken
Over the past 13 years, and including the recent market advance, the S&P 500 has underperformed even the minuscule return on risk-free Treasury bills, while experiencing two market plunges in excess of 50%. I am concerned that we are about to continue this journey. At present, we estimate that the S&P 500 will likely underperform Treasury bills (essentially achieving zero total returns) over the coming 5 year period, with a probable intervening loss in the range of 30-40% peak-to-trough.
Why? First, with respect to 5-year prospective returns, it's important to recognize that returns at that horizon are primarily driven by valuations - not the "Fed Model" kind, but the normalized earnings and discounted cash flow kind. Stocks remain strenuously overvalued here, and only appear "fairly priced" relative to recent and near-term earnings estimates because corporate profit margins are more than 50% above their long-term norm. Meanwhile, corporate profits as a share of GDP are about 70% above the long-term average. As I detailed in Too Little To Lock In, these abnormally high margins are tightly related (via accounting identity) to massive fiscal deficits and depressed household savings rates, neither which are sustainable.
Our projection for 10-year S&P 500 total returns - nominal - is about 4.4% annually, which is far better than the 2000 peak, far inferior to the 2009 trough, and save for the period before the 1929 crash, worse than any prospective return observed prior to the late-1990's bubble - even in periods having similarly depressed interest rates.
Of course, rich valuations can persist for some time - predictably resulting in poor long-term returns, but often doing little to prevent short-run speculation and temporary gains. The issue is then to identify the point at which overvalued conditions are joined by sufficiently overextended conditions, and a sufficient loss of speculative drivers, to make rich valuations "bite" even in the shorter-term. This is where additional criteria come in, such as overbought technical conditions and extreme optimism in the form of low bearish sentiment, depressed mutual fund cash levels, and heavy insider selling. Presently, it doesn't help that T-bill yields and long-term bond yields remain higher than 6 months ago, and we have signs of oncoming recession. This is particularly evidenced by collapsing economic measures in Europe, softening economic performance in developing economies including China and India, and jointly weak year-over-year growth in key U.S. economic measures such as real personal income, real personal consumption, real final sales, and reliable leading indicators from the OECD and ECRI, as well as our own measures.
With regard to global Purchasing Managers Indices, the latest data from Markit shows fresh deterioration in European PMIs measuring output, with Germany still slightly above the 50 level that distinguishes expansion from contraction, but the rest of the Eurozone clearly weakening on these measures.
The deterioration is also evident in PMIs tracking retail sales, where activity has slowed abruptly both in “core” countries such as Germany and France, as well as “peripheral” countries such as Italy.
The combination of rich valuations, overbought conditions, overbullish sentiment, and deteriorating leading economic evidence can still unfortunately persist for months before being resolved. But once the hostile syndromes we've seen recently have emerged in the data, attempts at continued speculation have amounted to playing with fire. Similar conditions have repeatedly resulted in disastrous outcomes for investors. It would be nice to be able to "time" these outcomes better. We haven't found a reliable way to do so, and would still be concerned about robustness - sensitivity to small errors - even if we did. Yet even when unfortunate outcomes are not immediate, the fact that the S&P 500 has underperformed T-bills for 13 years is not very sympathetic to arguments that stock market risk has been worth taking overall, except in confined doses.
With regard to those doses, this would not be the time to swallow one. We presently identify market conditions as being in the most negative 1% of historical data based on the average expected return/risk characteristics associated with similar conditions, on a wide range of horizons ranging from 2 weeks to 18 months.
It may be helpful to put present conditions in context of what we consider "normal" in terms of our hedging strategy. The recent combination of speculation in "risk-on" sectors, coupled with the familiar string of marginal new highs (typical of the "overvalued, overbought, overbullish" syndrome) isn't very pleasant for a defensive position, at least until the market hits the equally familiar "air pocket" - which hasn't happened yet. So it's useful to understand our present stance from a longer-term perspective.
Looking back over much of the past century, our present defensive stance (fully hedged with "staggered strikes") is a position that corresponds to conditions we find in less than 7% of the historical data. As noted, current conditions are actually among the most negative 1% of the data, but we are already at the most defensive position our strategy contemplates, so from a strategic perspective, the worst 7% is indistinguishable from the worst 1%. The distribution of these defensive positions is worth noting. Historically, the hedging stance supported by our approach would have been equally defensive in just 3% of periods prior to 1999 (for example, during portions of 1973-74 and 1987), but 23% of the time since 1999 (for what should be obvious reasons given the steep declines and weak overall returns we've seen since the late-1990's valuation bubble).
Prior to 1999, the data would have indicated a fully unhedged stance about 60% of the time, often with a small overlay of call options representing a few percent of total assets (this makes sense given the far better valuations and correspondingly strong subsequent returns that were available through most of history). Since 1999, however, a partially or fully hedged stance would have been indicated nearly 85% of the time, with the exceptions being 2003 and early-2004 (when in fact, we removed the majority of our hedges), and during much of 2009 and early-2010 - which was a difficult period for us in practice, due to my insistence on stress-testing against Depression-era data (the February 6 comment Notes on Risk Management discusses the unusual 2009-2010 period as it relates to our hedging approach).
In short, our average stance since 1999 has been far more defensive than we would consider "normal" on a longer historical basis. But then, a 13-year period where stocks underperform even depressed and near-zero T-bill yields is certainly not normal by any historical standard either. These conditions will change, but at present, a tightly hedged position remains essential.
Release the Kraken
The problem for the stock market is that the 13-year journey of underperforming T-bills - with wicked collapses and break-even recoveries - is most probably not over. Stocks remain overvalued on the basis of the probable long-term stream of cash flows they will deliver to investors, though the extent of this overvaluation is obscured by unusually high (but reliably mean-reverting) profit margins, which make current and forward P/E ratios seem pleasantly digestible.
There are two ways to think about this. One is to think of these rich valuations and low prospective returns as a durable feature of the market environment. That's basically the vision that PIMCO's Bill Gross recently suggested, noting that we have entered a period of "negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come." His take is well worth the read. That said, an alternate possibility is that we will see a more rapid adjustment as investors lose the apathetic overconfidence that they can ignore the risks of a global economic downturn, massive and recurrent sovereign debt crises, and an implosion of the European banking system. In that event, we are likely to observe a significant increase in risk premiums toward more historically normal levels, but followed by a more gradual recovery in risk assets than the one that followed the 2008-2009 crisis.
My impression is that the Kraken is about to break loose, as valuations are rich and dependent on permanently high profit margins, speculators appear "all in" based on depressed bearish sentiment, mutual fund managers have whittled their cash holdings to nearly zero and have taken on unusually high beta risk, Europe is already in recession, and we are seeing a broad deterioration in U.S. economic data, as coincident evidence catches up with what we've persistently observed in the leading evidence in recent months.
Once upon a time, the stability of European government debt, the solvency of the European banking system, the prospects for the euro, and the speculative elements of the financial markets were all fairly distinct aspects of the financial landscape. Unfortunately, as the result of bailouts, monetary interventions, accounting changes, watered-down capital standards, and other kick-the-can strategies, all of these issues have become glued together, as the whole world has gulped down the elixir sold from the wagon of Ben Bernanke's Traveling Medicine Show. In response to strains in the European banking system due to risky sovereign debt holdings, the ECB made loans to those banks in return for "collateral" in the form of newly issued, unregistered bank debt, and the banks used much of the proceeds to take even larger positions in sovereign debt, against which no capital needs to be held. So rather than "fixing" the problem, the ECB simply bound the problems of the European banking system more tightly to its own balance sheet, and to the fiscal strains of European governments. Nobody cares right now - I get it. But understand that this is likely to end badly, particularly given that government debt typically grows sharply during recessions.
For our part, we would greatly prefer to deal with the adjustments that are necessary for robust economic growth, rather than just kicking the can down the road. This would include restructuring bad debt, removing the public and central bank guarantees that encourage reckless private behavior, establishing risk premiums that encourage savings, and reducing financial repression so that asset returns can provide useful signals for allocating capital well. Undoubtedly, central banks will fight against any of that, and the banking system will threaten "meltdown" in order to extract more bailouts in defense of bank bondholders. Still, it's worth repeating that even in recent years, Fed interventions have had their palliative effects precisely because they have emerged after the markets have already declined significantly. The hope of such interventions did not prevent significant downturns in 2011 and 2010, much less in the 2008-2009 period.
From a long-term perspective, the alternate courses don't matter a great deal. We expect 5-year total returns near zero for the S&P 500, and 10-year returns of just 4.4% (nominal). Again though, we would much prefer a "tooth-pulling" outcome in which the flat 5-year total return is distributed as steep market losses over a 2-year period followed by normal returns thereafter. I am optimistic that the market will establish a more normal return-risk profile (as the 1973-74 downturn produced, for example), which would enable a much more durable recovery without the constant need for risk-hedging. If instead, we face an extended period of financial repression, as Bill Gross suggests, we'll be forced to take our risk in more limited and periodic doses. Fortunately, present valuations - though rich - are well below the extremes we observed in 2000, so I would expect in any case that the next decade will require far less hedging than we've needed since those bubble highs.
We don't expect to be as defensive as we are at present for very long. But I continue to see that defensiveness as imperative here.
Notes on exponential revenue growth
One of the more fascinating aspects of a speculative market is the classic enthusiasm for new issues, and the emergence of growth "darlings" whose long-term exponential growth is taken as a sure thing. This movie has played so many times in the historical data that we've practically memorized the lines. Near the end of the tech bubble, I got myself a nice bit of criticism on CNBC when Alan Abelson of Barron's Magazine published my projections for Cisco, EMC, Sun Microsystems and Oracle - all in the range of about 15-20% of the prices where they had recently changed hands. Those projections actually turned out to be slightly optimistic.
Given that we're seeing some similar behavior today, it's probably a good time to discuss the dynamics of growth. Consider a very large, untapped market for some product. We can model the growth process in terms of how quickly that product is adopted by new users, whether there are any "network" effects where new buyers are attracted to the product because other people already use it, how frequently existing users replace their products, whether late-adopters come in more slowly than early-adopters because of budget constraints, how quickly the untapped market grows, and a variety of other factors.
Whether you do this sort of modeling with a spreadsheet or with differential equations, you'll get essentially the same results. Specifically, growth rates are always a declining function of market penetration. Most strikingly, the growth rates begin to come down hard even at the point that a company hits 20-30% market penetration. Network effects accelerate the early growth, but also cause growth to hit the wall more abruptly. Replacement helps to accelerate the early growth rates too, but ultimately has much more effect on the sustainable level of sales than it has on long-term growth. In fact, if the replacement rate (the percentage of existing users that replace their product each year) is less than the adoption rate (the percentage of untapped prospects that are converted to new users), it's very hard to keep the growth rate of sales from falling below the rate of economic growth.
The chart below gives the general picture of various growth curves and the effect that different factors can exert. The paths are less important for their actual growth rates as they are for their general profiles (below, I've assumed that 15% of the untapped market adopts the product each period). It may seem odd that you could get a growth rate below the adoption rate. But notice that with an adoption rate of 15% and a total potential market of 1000 units, for example, you'll sell 150 units the first year, but the next year's sales will only be 15% of the 850 remaining untapped prospects, so growth will actually be negative unless you have other factors contributing, such as discovery, replacement, network effects, and so forth.
To see how all of this has played out in the actual data for past market darlings, let's take a look at several extraordinary growth companies that can now reasonably be viewed as having reached their "mature" level of market penetration: Microsoft, Cisco, Intel, Oracle, IBM, Dell and Wal-Mart. The chart below presents the combined scatter of historical revenue growth and penetration data for these companies. Again, the key feature is that growth rates are a rapidly decreasing function of market penetration.
With regard to the elephant in the room, which is Apple, my impression is that what appears to be endless exponential growth is actually the overlay of three separate logistic growth curves - one for the iPod, one for the iPhone, and one for the iPad. These are great products. Still, in order to maintain even a constant level of sales, every unit sold in a given year has to be matched by a replacement the next year - year-after-year - or it has to be matched by a new adoption, and adopters of used products don't count. Simply put, even zero growth demands that every dollar existing users spent on Apple products last year has to be spent again this year, or matched by some new user this year, and then again next year, and again the year after that, ad infinitum. Of course, it's reasonable to expect that late-adopters (e.g. those who have to save in order to afford the product) will have lower replacement rates, which will need to be offset by even greater adoption. Yes, there are billions of people in developing countries without an iPhone. Unfortunately, most of these people are also without running water.
We've seen very rapid adoption rates, very high replacement, and very strong network effects in Apple's products. All of this is an extraordinary achievement that reflects Steve Jobs' genius. I suspect, however, that investors observe the rapid adoption and very high recent replacement rate of three very popular but semi-durable products, and don't recognize how improbable it is to maintain these dynamics indefinitely. Despite great near-term prospects, within a small number of years, Apple will have to maintain an extraordinarily high rate of new adoption if replacement rates wane, simply to avoid becoming a no-growth company. That's not a criticism of Apple, it's just a standard feature of growth companies as their market share expands. It's something that Cisco and Microsoft and every growth juggernaut encounters. Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak. Not that things worked out well for investors who paid those valuations. There's always the hope that this time it's different.
As of last week, market conditions remained within the most negative 1% of historical return/risk profiles we've observed over time. This will change, of course, as nearly all of market history lies outside of this subset. But while these conditions persist, we remain strongly defensive. Strategic Growth and Strategic International are tightly hedged, while Strategic Dividend Value is hedged at about 50% of the value of its stock holdings, which is its most defensive stance. Strategic Total Return continues to carry a duration of just under 3 years in Treasury securities, with about 12% of assets in precious metals shares, and a small percent of assets in utility shares and foreign currencies.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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