Last Wednesday night on "The Kudlow Report" with Sir Larry Kudlow it was Tony Orlando and Dawn ... though really, it was Phil Orlando and Doug tying a ribbon around old Mr. Market!
"Tie a yellow ribbon 'round the old oak tree
It's been three long years
Do you still want me?
If I don't see a ribbon round the old oak tree
I'll stay on the bus
Forget about us
Put the blame on me
If I don't see a yellow ribbon round the old oak tree."
-- Tony Orlando and Dawn, "Tie a Yellow Ribbon"
Phil is a thoughtful strategist, and I have admired him over the years -- in his previous gig at Value Line and now as chief equity market strategist at Federated Investors -- so it was fun being with him last week.
For me, it's been a long year since I have been as optimistic as I am now -- so the song seems appropriate!
My main point on "The Kudlow Report" was that I am growing more optimistic about the U.S. stock market's prospects, and I am of the view that it's now time to be expanding one's commitment to stocks.
(What follows is in part what I discussed on the show, but I am expanding the core points I made into a broader "Where I Stand Now" missive.)
Twelve months ago we entered 2011 with a wide range of concerns. My worries included, but where not limited to, structural unemployment and mounting fiscal balances (at the local, state and federal levels). I expected a foul mood to weigh on consumer and business confidence and on economic growth. As well, I envisioned a deepening recession in Europe. My outlook for the stock market was negative and I thought stock valuations were vulnerable and would be exposed to these developing headwinds.
Throughout most of the year I suggested that the U.S. stock market would be unstable until volatility quieted down, our political leaders favored compromise over division, European leaders and central bankers adequately addressed a growing debt crisis and until the domestic economic data improved (especially after the sharp erosion in confidence during the late summer).
By contrast, most market observers entered 2011 with far more optimistic economic expectations (of a "normal" self-sustaining economic recovery) and with stock market forecasts that generally contemplated a 15%-20% rise in the major Indices.
For 2011, domestic real GDP growth ended up only about 1.8%, or approximately half the rate of growth that the general consensus anticipated. Corporate profits rose by 16% but most market indices were negative on the year as price-to-earnings ratios contracted.
In contrast, as we enter 2012, the optimistic economic and market consensus of a year ago has turned far more subdued. Reflecting more downbeat economic growth and investor expectations, individual investors (taking another $100 billion out of domestic equity funds) and hedge funds (now at their lowest net long exposure since the Generational Bottom in March 2009) have materially de-risked.
Consensus rarely triumphs in the stock market, and I see 2012 as another year in which the consensus will be wrong.
While I fully recognize the world is imperfect, the blemishes are now well known and, arguably, incorporated in current share prices. More importantly, three of our four concerns (high volatility, a mounting European debt crisis, a weakening domestic economy and the division between the Republican and Democratic parties) are moving in the right direction. And, the fourth, our divided leadership incapable of compromise, might now be coming closer to resolution with a country that appears to be leaning toward the Republican party (I am a Democrat). A close Romney win is now my baseline expectation, and such a political outcome would be more market-friendly than would occur with another four years under President Obama.
I am particularly more optimistic that the U.S. economy's growth trajectory will exceed the expectations of only two or three months ago given the improvement in jobless claims, better-than-expected ISM and PMI readings, strength in automobile sales, etc. Concerns of a double-dip recession have vanished and the outlook for 2012 corporate profits has improved over the past 60 days.
In Europe, political leaders and central bankers are slowly addressing their sovereign debt problems. Though tame and timid in approach at the outset, more "shock and awe" has been employed -- and more is likely on the way. It is my view that the eurozone affliction is moving toward a condition that can be tolerated by the markets (but must always be monitored).
Another market-friendly condition is that central bankers around the world have signaled increasingly accommodative monetary policies. With inflation quiescent, low short-term interest rates are likely to remain for some time.
With better economic growth ahead in the U.S. and the hope for some stability in Europe, a meaningful rotation out of bonds and into stocks is a growing possibility. As I have previously written, U.S. stocks have had an average P/E multiple of 15.3x over the past 50 years, while the yield on the 10- year U.S. note has averaged 6.67%. Today, U.S. stocks trade at only 12.5x with the yield on the 10- year U.S. note at around 2%. Moreover, historically U.S. stocks have been valued at 17x-18x when interest rates and inflation (and inflationary expectations) are around current levels.
Risk premiums (the earnings yield less the risk-free cost of capital) are now elevated and back to levels last seen in 1974 as European sovereign debt issues have accentuated the flight to safety. It is important to note that following the last spike in risk premiums 37 years ago, the S&P 500 index returned +35% and +19% in 1975 and 1976, respectively.
These low stock market valuations (mentioned above) will likely serve as a margin of safety for stocks. I also believe strongly that conditions have evolved over the near and intermediate term that have conspired to favor risk assets in the U.S. over many other areas of the world.
Here are 10 previously mentioned reasons for my optimism that a potential rotation into U.S. assets and out of non-U.S. assets might be forthcoming:
To summarize, I believe 2012 will be a surprisingly good year for the U.S. stock market. I anticipate that domestic economic and profit growth will surprise to the upside, and I am of the view that market valuations will expand (after contracting in 2012). If Europe settles down, the flight to safety of 2010-11 should become a thing of the past this year, and fixed-income instruments could take the brunt of the damage in a potentially large reallocation out of bonds and into equities.
I fully recognize that the slow worldwide economic growth exposes economies and markets to exogenous shocks, but I also think much is discounted in current prices. The world is imperfect and, reflecting that condition, I am not "over our skis" long. Rather, my net long exposure of about 60% is hopefully a balanced and objective reflection of the imperfections that exist today and that constrain valuations -- most notably, a recognition of imprudent domestic policies that have led to our country's fiscal imbalances.
Reflecting my emerging optimism I have been gradually expanding my net long exposure and -- assuming my baseline economic, political and European policy expectations are not altered -- I expect to opportunistically add to my long investments, especially during bouts of market weakness ... which we will surely experience from time to time.
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