Predicting market direction during 2009 was a no brainer. While at the start of the year it was impossible to know how far markets would fall, it was easy to predict the end of year level as upwards. Similarly, 2010 was a no brainer. My SP500 outlook for 2010 said:
"In my view values are not expensive at 15X 2010 earnings expectations; particularly when considering yields in the bond market.
For 2010, I expect a re-test of fair value with markets falling to 960 to 980 levels. As confidence in earnings builds, I expect markets to rise; in my view 1,350 is a likely peak value for 2010 with 1,250 as the most likely target for end 2010."
That's close enough for me.
2011 will be a more difficult year to predict. On the one hand valuations are cheap, risk aversion remains high, the rear view mirror still shows ravages of the past recession, leading indicators and long leading indicators are positive and the history of economic cycles tells us that the peak of the present economic cycle is a way off.
Valuations are cheap: Using FY2010 operating earnings estimates of $82.50 and SP500 at 1,234, the market is trading at 14.96X. This compares with a decade average of 17.64X; a level of 1,411 would be required to match decade median multiples. Median earnings over the six year period from 2005 to 2010 is $79.48; this gives a market multiple of 15.52X median earnings over a typical six year economic cycle. This 15.52X multiple compares with decade multiples of 21.27X historic 6 year median earnings. Ultimately, the markets are no longer dirt cheap, but I doubt very much that they will fall significantly until a cycle of reversion to median multiples is complete.
Risk aversion remains high: Gold continues to do quite well. At the same time US treasuries have still attracted major money flows. Corporate debt spreads between Aaa bonds and the 10 year note remain wide compared to historic spreads; Baa versus the 10 year note remain wider still. Significant money needs to come out of these asset classes to return equity allocations to near normal levels. On the other hand, consensus is long risk and that is apparent from commodity prices, particularly oil and copper, and risk premiums narrowing in emerging economics both in equity valuations where multiples are at top quartile levels, as well as corporate debt spreads, which have narrowed to below long term averages. And this is moderately worrying.
Risk aversion is not near recession levels; appetite for commodities, growth, midcap and emerging economy stocks indicates a return of risk taking – but it has still not normalized.
The rear view mirror: When we look in the rear view mirror, the picture still looks ugly. Growth remains low and unemployment elevated. Markets do not normally peak until the rear view mirror paints a rosy picture. They can, a double dip could certainly push the market over, but leading and long leading indicators tell us that risk is out for now. The biggest support for markets will be a substantial rise in prior year earnings; in 2010 people look back to 2009 and see operating earnings of $57 – while 2010 earnings are expected to come in at a respectable $82.50, that quick glance back to 2009 earnings does not provide support to higher multiples. During 2011, we could see operating earnings at over $90 and when we look back to 2010, it will look respectable at $82.50; this could provide strong support to downside in markets next year.
Leading indicators and long leading indicators: new orders, jobless claims, money supply, average workweek, building permits, and stock prices are indicating improvements over the coming months. The more rate of change in economic growth is also encouraging. The fiscal and monetary actions of US with tax cut extensions and QE2 also show intent to support growth; such actions are likely to stimulate near term growth over the coming few months.
History of economic cycles The last 23 economic cycles have covered 1899 to present; we are now in the 24th economic cycle. History tells us that when contractions in economic activity have been long, so too have the post contraction expansions been long. The 1902/04 contraction lasted 700 days; the subsequent expansion lasted 1,003 days. The 1910/12 contraction lasted 730 days; the subsequent expansion lasted 366 days. The 1913/14 contraction lasted 699 days; the subsequent expansion lasted 1,339 days. The 1920/21 contraction lasted 547 days; the subsequent expansion lasted 669 days. The 1923/24 contraction lasted 427 days; the subsequent expansion lasted 822 days. The 1926/27 contraction lasted 396 days; the subsequent expansion lasted 639 days. The 1929/33 contraction lasted 1,308 days; the subsequent expansion lasted 1,522 days. The 1973/75 contraction lasted 485 days; the subsequent expansion lasted 1,767 days. The 1981/82 contraction lasted 488 days; the subsequent expansion lasted 2,799 days. All other contractions were not of a length sufficient to be comparable to our present circumstances.
The Dec 2007 to June 2009 contraction lasted near 548 days. History indicates that the next economic peak will be closer to November 2012 and it may be as far as November 2013, depending on whether you use average peak to peak or average trough to peaks as measures to indicate the longevity of the present expansion.
Do keep in mind that expansions following intense and long duration contractions are long but slow. It is very common for markets to rally for the first two years following a few months prior to the recession end and then to remain weak for the remainder of the economic cycle. Our markets could peak half way through 2011 even while an expansion in economic activity continues. Such market behavior is wholly consistent with secular bear markets. However, it may not apply to emerging markets and commodities which are in secular bull markets; though these secular bulls are negated in part and hurt by the larger global secular bear.
The presidential cycle: In year 2, influence normally comes from fiscal policy; this time it has been supported by monetary policy. In year 3, normally stimulative monetary activity occurs; this is unlikely to change. QE2 with an indication that more will follow if required is visible; but what is not considered is the risk that it will be withdrawn if it's not needed. The year 3 monetary stimulus combined with year 2 fiscal stimulus normally provides a strong year 3 of the presidential cycle for the stock markets. And year 4 is the year when Wall Street may not be so happy, but main street and the real economy looks quite nice. There is a real risk that if inflation kicks in vigorously, the monetary stimulus will be withdrawn.
On balance, 2010 has been a year of fear; money has flowed to bonds despite the very apparent over valuation – will 2011 be the year of greed? The long risk consensus together with ignoring magnificent sovereign debt problems tells me that at least part if not all of 2011 will host the feast of greed.
During 2011, I am looking for a target of 1,350 with a strong chance that markets hit 1,400. I expect this target to be achieved by late q2 2011. After this I expect weakness in the markets with a moderately downward drift through mid 2012; this while the economy strengthens as a result of fiscal and monetary policy during 2011. All said and done, expect valuations to remain subdued in a historic context (15-16X) compared with 18X in recent years – but expect dividend payouts to continue to rise with sound earnings growth.
After mid 2012, we are likely to see a severe fall in markets as the present cycle enters its end cycle trough. While I expect reduction in unemployment to be spectacular during the coming months, it is likely that unemployment will remain high near the present cycle peak, in comparison with prior economic cycle peaks. Interest rates on the other hand, will likely be low in contrast with prior economic cycles. I suspect inflation will be elevated in comparison with prior economic cycles. And nations and individuals are and will remain over-leveraged; the deleveraging cycle is nowhere near complete and this poses systematic and unsystematic risks to financial services sector. It is likely that much debt destruction needs to occur before that is over and done.
The next recession will not be an easy situation to handle, though perhaps less of a surprise than our recent recession! The message that has to be delivered is hard; the messenger runs the risk of being shot – telling people that they need to work longer (retire later), live cheaper (save more & pay more tax) and die younger (less healthcare) is not welcome – but it's necessary – seigniorage, higher taxes, inflation and growth is not enough; strong fiscal discipline by individuals and governments, must be exercised before economic health with any sense of longevity can return.
Beware of year forecasts; widen your time horizon to an economic cycle. At over 1,200 SP500 is probably trading at over the cycle mid-point range of 800 on the downside to 1,400 on the upside. I would suggest investing in risk – growth over value, commodities & cyclical over defensives, mid cap over large cap for now. But once markets approach 1,325, start unwinding risk and work towards building a very defensive bias with focus on dividend paying large caps with strong brands and sound balance sheets, and in sectors which suffer less earnings volatility over the course of an economic cycle.
