FMX | Connect – www.fmxconnect.com - (Reported 7/20/2010)
Excerpt from MARKET MUSINGS & DATA DECIPHERING
Q&A WITH THE BEAR
Gregory Zuckerman at the Wall Street Journal just published a Q&A on the market and the macro outlook, featuring me alongside James Paulsen, Chief Investment Strategist at Wells Capital Management, whom I like a lot, but basically disagree with 99% of his views. Mr. Zuckerman only had so much space and while he did a great editing job, what I thought I would do is pass below the full-fledged responses from my end. Enjoy!
Where is the market headed the rest of this year and over the next 12-18 months?
The market, like life and the seasons, moves in cycles — 16 to 18 year cycles, in fact. Sadly, this secular down-phase in the equity market began in 2000 when the major averages hit their peak in real terms, and so the best we can say is that we are probably 60% of the way into it. This by no means suggests that we cannot get periodic rallies along the way, but in a secular bear market, these rallies are to be rented, not owned.
In contrast, corrections in a secular bull market, as we saw in 1987 (as scary as it was) are opportunities to build long-term positions at more attractive pricing. In secular bear markets, the indices do hit new lows during the recessions (ie, 2002, 2009), when they occur; in secular bull markets, you do not make new lows — they are just corrections (ie, 1987, 1990, 1994, 1998).
The market is not as cheap as the pundits, who rely on year-ahead EPS estimates, deem it to be. When one incorporates cyclically-adjusted corporate earnings in ‘real’ terms, equities are still roughly 20% overvalued even after the recent correction.
More fundamentally, it would seem reasonable to expect that the equity market will trade down to a valuation level that is historically commensurate with the end of secular bear markets. This would typically mean no higher than a price-earnings multiple of 10x and at least a 5% dividend yield on the S&P 500. So, we very likely have quite a long way to go on the downside.
But it will not be a straight line and there will be intermittent rallies, as we experienced a year ago April; however, not even that 80% bounce off the lows managed to violate any of the long-term trend lines, which continue to portray a primary bear market, not unlike what we endured from 1966 to 1982. Back then the principal cause was an inflationary spiral; this time it is a deflationary debt deleveraging that is the root cause. Within the next 12 to 18 months, I can see the S&P 500 breaking back below 900, and a substantial test of the March 2009 lows cannot be ruled out.
What should investors do with their portfolios?
My primary strategy theme has been S.I.R.P. (Safety and Income at a Reasonable Price) because yield works in a deleveraging deflationary cycle. Not only is there substantial excess capacity in the global economy, primarily in the U.S. where the “output gap” is close to 6%, the more crucial story is the length of time it will take to absorb the excess capacity. It could easily take five years or longer, depending of course on how far down potential GDP growth goes in the intermediate term given reduced labour mobility, lack of capital deepening and higher future tax rates. This is important because what it means is that disinflationary, even deflationary, pressures will be dominant over the next several years.
Moreover, with the median age of the boomer population turning 55 in the U.S., there is a very strong demographic demand for income and with bonds comprising just 6% of the household asset mix, this appetite for yield will very likely expand even further in coming years. Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible, so a reliance on reliable dividend yield and dividend growth makes perfect sense.
We are in a period of heightened financial market volatility, which is typical of a post-bubble deleveraging period when the forces of debt deflation are countered by massive doses of government reflationary polices. This to-and-fro is the reason why in the span of a decade we have seen two parabolic peaks in the equity market (September 2000 and October 2007) and two depressed bottoms (October 2002 and March 2009). As I have said before, 80% rallies in a 12-month span, as we saw in the year to April, last happened in the early ‘30s and were followed by gut-wrenching spasms to the downside. So for any investor, return of capital is yet again reemerging as a very important theme, and the need to focus on risk-adjusted returns. This, in turn, means a strategy that minimizes both the volatility of the portfolio and the correlation with the equity market is completely appropriate — the best way to play this is with true long-short hedge fund strategies.
Gold is also a hedge against financial instability and when the world is awash with over $200 trillion of household, corporate and government liabilities, deflation works against debt servicing capabilities and calls into question the integrity of the global financial system. This is why gold has so much allure today. It is a reflection of investor concern over the monetary stability, and Ben Bernanke and other central bankers only have to step on the printing presses whereas gold miners have to drill over two miles into the ground (gold production is lower today than it was a decade ago; hardly the same can be said for fiat currency).
Moreover, gold makes up a mere 0.05% share of global household net worth, so small incremental allocations into bullion or gold-type investments can exert a dramatic impact. Gold cannot be printed by central banks and is a monetary metal that is no government’s liability. It is malleable and its supply curve is inelastic over the intermediate term. And central banks, who were selling during the higher interest rate times of the 1980s and 1990s, are now reallocating their FX reserves towards gold, especially in Asia.
David A. Rosenberg
Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919
Source: Market Musings & Data Deciphering
http://www.fmxconnect.com/
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