The Bullish Stars Are Aligned - 11/07/11

I am now much more responsive to long investment ideas.

As I will discuss in the body of today's opening missive (and in the Kass Model Portfolio update that will follow this post), I am growing more optimistic toward the U.S. stock market.

If share prices remain weak and assuming that my economic and profit expectations are unchanged, I expect to expand my long positions in the weeks ahead. But I will be disciplined, “wait for the right pitch” and not chase stocks higher.

I have generally been cautious (and underinvested) throughout most of 2011 as I have expressed a view that it was different this time, citing a troika of concerns that would serve as a headwind to domestic economic growth and would limit the upside potential for share price appreciation.

An imbalance between demand and supply in the U.S. housing market as a large shadow inventory of unsold homes would weigh on home prices (and on consumer balance sheets).
Divided and divisive political leadership unable to agree to and enact hard-hitting, pro- growth fiscal policy.
Structural disequilibrium in the labor market which would lead to an elevated unemployment rate.

Domestic economic growth in the first half came in far less than consensus forecasts and basically supported the above concerns that I had previously expressed, with real GDP rising by less than 1%. And, while there was a great deal of volatility thus far in 2011, the S&P 500 has made little progress and stands today basically unchanged from year-end 2010.

Slowly, most economists (and even the Fed) have finally accepted my long-term view that forward economic growth will be subpar and that the trajectory will be uneven.

Over the past few months, I have written on Real Money Pro that there were four conditions necessary for us to become more optimistic regarding the outlook for stocks:

the market’s volatility would need to subside;
the sharp division in Washington, D.C. must turn toward compromise;
forceful policy in the eurozone was necessary to stem the debt crisis; and
I wanted to see a stability/improvement in the hard domestic economic data (which would negate the possibility of an economic downturn or double-dip).

While volatility remains heightened, the other three conditions are slowly turning more positive. And, even as I reflect about the tortuous volatility, do not the fear of uncertainty and the wild daily price moves represent precisely the time when one should be invested?

“In the twentieth century, the United States endured two World Wars and other traumatic and expensive military conflicts, the Depression, a dozen or so recessions and financial panics, oil shocks, a flu epidemic, and the resignation of a disgraced President. Yet the Dow rose from 66 to 11,497.”

-- Warren Buffett

Before I discuss the slow improvement in the three other factors, I want to emphasize that I am keenly aware of the worldwide risks associated with the impact of the current balance sheet retrenchment and the challenges associated with numerous secular headwinds. The world’s economic recovery is imperfect, and with the U.S. economy exhibiting only moderate growth, there is little margin of safety for exogenous shocks. But that imperfection and vulnerability are now universally recognized (contrasted with the optimism that existed a year, six months and three months ago) and are arguably reflected and more than discounted in reasonable/current valuations.

The Eurozone: Tangible progress in drafting a credible plan for the European debt crisis has started, and though this is not a permanent solution, a flawed plan is better than no plan at all. While stress points remain, crucial details are yet to be worked out and the likelihood of a European recession is high, systemic risk has been removed, and Thursday’s decision to lower interest rates by the ECB further supports intermediate-term stability in the region. I am growing more confident that, in the fullness of time, more permanent solutions will follow the current strategy (and the bailout's first step) of monetization and leverage. After all, the alternative is unimaginable for the eurozone economy's longer-term health.
The Political Theatre in Washington, D.C.: While a grand bargain in the U.S. (one that raises the Social Security retirement ages, raises the tax burden on the very rich, deals with the mortgage overhang, cuts the defense budget and eliminates the fiscal drag of 2012) is not likely, the super committee is now being forced to address the dual objective of assisting in generating economic growth while dealing with our fiscal imbalances. While I am not holding my breath, there have been press reports that some Democrats and Republicans might compromise on tax increases and entitlement spending cuts. We will know soon enough, as the super committee's deadline to submit its plan to Congress is only about two weeks from now. I am hopeful that the super committee and the rest of our political leaders have learned from the August circus in our nation's capital (that led to a plunge in confidence and in our equity markets) and will take some decisive steps to rise above their partisan interests.
The Domestic Economy: The weakening business and consumer confidence that appeared in August have not impacted the hard economic statistics in the fall, and concerns of a recession next year have receded. High-frequency economic data -- for instance, the regional and national ISMs, jobless claims, leading indicators and retail sales (among other indicators) -- are not at all consistent with recession. A market-friendly Fed (sticking with a policy of low short-term interest rates as far as the eye can see) should be supportive of moderate growth of about 2% over the next several quarters. With wage growth contained, 2012 corporate profits will continue to be elevated well above the level that many have feared would be the case earlier this summer.

“Most people get interest in stocks when everyone else is. The time to get interested is when no one else is.”

-- Warren Buffett

Besides the formation of a preliminary eurozone agreement and strategy, the forced agreement by the super committee in November and better high-frequency economic statistics, I see negative sentiment and reasonable valuations as a plus for stocks.

The downgrade in economic expectations (back to a more realistic view) and the combined impact of the eurozone debt contagion, the circus in Washington, D.C., and the U.S. debt downgrade over the course of the year have been accompanied by a souring in investor expectations, which is a necessary reagent to a better market. As I mentioned earlier, the major indices have exhibited little movement since the beginning of the year. More importantly, the S&P 500 sells at the exact same price as it did in December 1998 (13 years ago).

As a result, I do not feel as though I am paying up for stocks today.

In 2011, economic uncertainty (here and abroad) and unprecedented volatility have conspired to turn off major classes of investors who have de-risked. As a contrarian I rejoice in the fact that individual investors have redeemed $420 billion of domestic equity funds over the past five years while contributing $830 billion to (low-yielding) fixed-income products. That swing, of $1.25 trillion, since early 2007 is, by far, an all-time record change in preference of bonds over stocks.

The de-risking is not confined to retail investors, as, according to this week’s ISI Hedge Fund Survey, hedge funds’ net long exposure is the lowest since the generational low in March 2009. Moreover, pension funds' exposure is substantially skewed toward bonds over stocks, despite the meager yield returns. A massive reallocation out of fixed income and into equities remains a growing possibility, particularly if reduced corporate profit expectations prove to be too conservative and if there is better economic traction.

I lastly want to address current valuations, which I view as attractive. Risk premiums (the earnings yield less the risk-free rate of return) stand at a multi-decade high, placing stocks, in theory, even cheaper than at the March 2009 bottom. Looking out longer term in history, over the past 50 years the S&P 500 has averaged a 15.2x P/E multiple while the yield on the 10-year U.S. note averaged 6.67%. Today, the S&P 500 trades at only 12.5x (2012 earnings) while the yield on the 10-year U.S. note stands at only 2.05%.

In summary I have grown more optimistic as the fundamental, valuation, technical and sentiment factors seem to have aligned to be supportive of higher stock prices. I am pleased to have rejoined the investment land of the living, and I am now much more responsive to long investment ideas than at any time in the last year.

Color me more bullish.