Market Outlook from Dave Rosenberg

At the lows in the equity market last March, the S&P 500 was de facto pricing in -2.5% real GDP and $50 of operating earnings for the year. Guess what? Far from being grossly undervalued at the lows (though some stocks were — especially the financials, which were priced for bankruptcy) the market at the lows was fairly priced on a price-to-book and price-to-earnings basis. Usually at bear market lows, the S&P 500 goes to silly cheap levels. It never did this time around, and five months and 50% later, there is yet again, in 2007-style, tremendous risk in this market. Never before has the stock market surged this far, this fast, between the time of the low and the time the recession (supposedly) ended. What is “normal” is that the rally-ahead-of-the-recovery is 20%. This market is now trading as if we are in the second half of a recovery phase and yet it is not even been fully ascertained that the downturn is over — a one-quarter spurt in automotive production and sales induced by Cash-for-Clunkers is not enough to support the widespread assertion that the recession is behind us (the odds of a fourth quarter relapse, especially in the U.S. consumer, are non-trivial). This does not mean to say that a momentum and technically driven market can't go even higher over the near-term — equity prices have already surged to levels that have taken us by surprise. The memory of the recession and credit crisis seems to have faded and greed has very quickly replaced whatever fear there was that gripped the market through last winter. Market psychology has shifted dramatically — to the point where Intel's "positive guidance" is taken as a positive even though prior estimates were lowered to the basement floor, and now payroll declines of 250k are treated with a palpable sense of relief. Housing and autos bottomed because of massive government intervention but it is unclear what the economy looks like absent all of the medication. The history of post-bubble credit collapses is replete with examples of lingering economic fragility long after the hurricane passes, and initial bursts of euphoria at the first whiff of recovery — as we saw in 1932 and 2002 in the U.S.A. and 1991 in Japan — are proven to be unsustainable. Investors are frustrated to have missed out on the rally from the March lows, but what they must appreciate is those who went long the market this year had to ride out the sharp decline in the first three months of the year and took on substantial risk to achieve their outsized capital gains. A 50% bounce off the lows — and who exactly bought at the lows — came at the cost of too many sleepless nights, in our opinion. We will take a longer term view and await either better pricing or more conclusive signs that the private sector can stand on its own two feet — or a combination of both. Buying at or near the highs is not a winning strategy. Remember — the reason the tortoise won the race is because the hare tired himself out. Housing and autos bottomed because of government intervention… but what will the economy look like absent all of the medication. Remember, Mr. Dow and Mrs. Jones are not always rational beings We have been willing to express a cyclical view more through the fixed-income market, namely our corporate bond and premium income strategies. Based on our research, Baa corporate bonds were pricing -10% at the widest spread levels, not -2.5% as the stock market was at the lows. Now that is silly-cheap and while the low-hanging fruit has ready been picked in the credit space, the corporate bond market is currently priced for 2% real GDP growth, not 4%. In other words, there is less risk in credit than there is in the equity market even after corporate spreads have been sliced in half from their depression-era levels. Remember — Mr. Dow and Mrs. Jones are not always rational beings. At the stock marker highs of October 2007, equity valuation was embedding a 5.0-5.5% GDP growth profile. What did we end up with? Try -1.8% on average over the next four quarters. In our research, we discovered that IF the stock market had priced in the true Armageddon -10% growth trajectory that the credit market had been discounting at its worst levels, the S&P 500 would have bottomed around the 315 mark. This puts the 666 diabolical low, as horrific as it appeared, into proper perspective. Flipping the analysis around, what if the stock market was pricing in the same 2% growth rate that the corporate bond market is now discounting. Answer is, 842 on the S&P 500. So, if you're asking us if we think we will see a 20% correction, the answer is yes. The next question is what peak level we correct from — or if in fact we have already seen the peak as the venerable Doug Kass has suggested (and echoed by the likes of Art Cashin today on page B1 of the NYT — “The people who know are getting out early … this rally’s a little long in the tooth”. Whether there is 100 points left in the S&P 500 from here to the upside over the near-term, it is seldom wise to chase an overvalued market to the top unless you are gifted enough to know when to call it quits. JP Morgan was fond of saying “I never buy at lows, I never sell at the highs, I play the middle 60%” (he actually told us this at a séance last week). Well, from our lens, we are well past that middle 60% point of this bear market rally. To reiterate, the equity market is overvalued and carries too much risk right now Indeed, when we look at the history books, to see what happens after the P/E multiple on trailing earnings pierces the 25x threshold, the average total return a year out is -0.3% and the median is -6.2%. The total return is negative a year later 60% of the time, so when we say that there is too much growth and too much risk embedded in the equity market right now, we like to think that we have history on our side. The next question naturally is where Baa spreads should be trading if it were to align itself with the 4% real GDP growth implicit in equity prices. The answer is, 200bps spreads over Treasuries or about 100bps tighter than they are today. To reiterate, the equity market is overvalued and carries too much risk right now. No sense paying Cadillac prices for a Ford Focus. In deflationary times, it pays to identify who has the pricing power and in the current context that means primary producers. So in addition to credit, commodities have also been an effective way to express a cyclical view this year. But commodities are more sensitive to global growth than is the case for equities, or corporate bonds for that matter, since Asia is the marginal buyer of basic materials. Our analysis shows that the CRB index is discounting between 2.5% and 3.0% global growth for the coming year, not wildly off the 2.0% consensus forecast despite oil prices more than doubling from the lows of earlier this year. In fact, the energy complex is only priced for 1.75% global growth versus 2.25-2.50% for forest products, and 3.00-3.25% for the base metals. So the oil price, followed by lumber/paper products would seem to have greater upside potential currently than say, copper and nickel.