Raindrops Keep Falling on Our Heads - 02/24/10

	The aggregated probability of adverse outcomes probably equals or slightly exceeds the bullish consensus.
	Hiring intentions are much more subdued than generally expected.
	As we proceed further into the new year, nontraditional headwinds loom closer and larger.

 

Raindrops keep falling on my head
But that doesn't mean my eyes will soon be turning red
Crying's not for me
'Cause I'm never gonna stop the rain by complaining
Because I'm free
Nothing's worrying me.

-- B.J. Thomas, "Raindrops Keep Falling on My Head"

While the magnitude of the drop in the Conference Board's Consumer Confidence Index seems suspicious and unjustified based on previous indicators (e.g., a more upbeat February University of Michigan confidence reading, growth in hours worked, stabilizing home prices, improving retail sales and other forward-looking economic reports), yesterday's release does reinforce my view that the economy on the ground is not as upbeat as the view of the economy in the charts.

As I have written repeatedly that, with so many cyclical and secular issues and headwinds to growth and a widening gap between the operating and financial health of large businesses vis-a-vis small businesses and the consumer, there are many more economic and market outcomes than usual that, in the aggregate, could offset the growing consensus of smooth and self-sustaining growth.

I continue to recognize that stocks are not meaningfully overvalued and that downside risk is limited. Stocks, unlike other assets classes (e.g., fixed income, private equity, residential and nonresidential real estate and commodities), have not had their valuations stretched. Most already expect a relatively shallow economic recovery. Also, inflation and inflationary expectations are subdued, and an elevated unemployment rate and large output gap are among the many reasons why the Fed will be on hold and the curse on cash will be intact for most of 2010.

Of late, there has been an increase in optimism with regards to profit growth based on better sales, improving margins (lower-than-expected unit labor costs) and rising cash flows, which are leading toward more aggressive share buybacks. The consensus for 2010 S&P 500 profit forecast is now moving toward (and even over) $80 a share, and the 2011 consensus is leaning toward the view that profits will exceed the previous 2007 record level of $92 a share.

Indeed, given low interest rates, benign inflation and reduced inflationary expectations, stocks, at under 13.5 times, remain statistically cheap against consensus 2010 S&P profit forecasts, far less than the historic P/E multiple of 17.5 times under similar interest rates and inflation readings.

I don't disagree with the possibility of a normal, self-sustaining business expansion and the attainment of consensus earnings, but I do strongly believe that there are numerous impediments and potentially disruptive outcomes that could upset a benign outcome; the aggregated probability of adverse outcomes probably equals or slightly exceeds the bullish consensus.

Most important, the past cycle was not a traditional cycle and the outgrowth of further deleveraging, negative policy initiatives and other economic factors out of the last cycle will loom with a long tail. The past cycle was an unprecedented credit-driven cycle characterized by the excessive and abusive use of debt/leverage. So, following that halcyon cycle of credit, the current expansion, which is soon to be deprived of many of the steroids that built that growth, seems capable of disappointing an increasingly confident cabal of forecasters of smooth and self-sustaining progress.

The sharp drop in yesterday's consumer confidence release and its potential negative impact on jobs growth (i.e., the lifeblood to the bull case), coupled with the stock market drop, are just more reminders that less benign economic outcomes loom and that consensus expectations may be threatened in a world still very much impacted by the financial crisis that ended a year or so ago.

My baseline expectations are unchanged (and remain less optimistic than consensus):

• In 2010, markets will have a limited memory from day to day, which can be frustrating for long-term investors but a great backdrop for opportunistic traders who are willing to buy the dips and sell the rips and for investors willing to sell premium.

   

• I continue to believe that the U.S. stock market will show little movement during the first quarter despite far better-than-expected top- and bottom-line growth in fourth quarter 2009 and better sales and earnings guidance for first quarter 2010. Markets have discounted the recent earnings recovery and will now await clearer signs of sustainable growth.

   

• The S&P will likely be stuck in a trading range between 1,025 and 1,150 over the next six to nine months, and I expect that we will end the year at the lower end of that range. Nine-month corrections often follow the first year of multiyear market advances (e.g., in 1994 and 2004).

   

• For the full year, the major market indices will likely exhibit a high-single-digit loss (down 5% to 10%).

Regardless of one's short-term view, the nontraditional challenges facing the capital markets are multiple and remain threatening. Most of these factors are economic- and valuation-deflating, serving to cap the upside to a statistically inexpensive U.S. stock market in 2010, and argue against the view that we are embarking upon a normal, durable (40-month-plus) and self-sustaining upcycle:

• Populist policy means more costly regulation and higher marginal taxes for the wealthy and our largest corporations; it also means that small business confidence will remain subdued, as will hiring and expansion plans.

   

• The imbalance between revenue and receipts for state and local finances means higher sales taxes and less service. Municipal employment rolls will contract, unlike in prior economic recoveries.

   

• A still-leveraged consumer facing wage deflation and higher inflation means higher savings and lower personal consumption expenditures. Decades of an aspirational consumer might be reversed -- that is, the definition of a better life could mean more money in the bank and less stuff.

   

• The absence of job growth at small businesses in the face of regulatory and tax uncertainties and the reluctance of large corporations to take on new hires as they seek further productivity gains guarantees that unemployment will remain elevated. With our population growing and our manufacturing base declining (as our global competitiveness deteriorates), from where will the jobs be generated?

   

• The residue of the housing boom is an unprecedented large phantom inventory of unsold homes that will weigh on the slope of the residential real estate market's recovery. While commercial real estate could weather the downturn far better than the bears expect, it, too, will not be a driver to economic growth in the years ahead.

   

• The threat of due bills (higher interest rates and inflation) down the road remains an albatross around the neck of the market's P/E multiple. The U.S. fiscal house is in disorder: Deficits are ballooning, and our educational system, Medicare and Social Security are severely underfunded. How long and at what cost can we expect foreign central banks to fund domestic growth?

   

• Geopolitical threats are rising.

In summary, yesterday's consumer confidence drop (though likely overstated) is a reminder that numerous economic outcomes for 2010 exist that could serve to upset the market's equilibrium. It also supports my view, consistently seen in my ongoing discussions with company managements, that hiring intentions are much more subdued than generally expected.

The expectation of disappointing 2010 employment growth remains the single most important area where I disagree with the bullish consensus.

From my perch, the economy on the ground remains less healthy than it appears in the charts. Moreover, as we proceed further into the new year, nontraditional headwinds loom closer in time and perhaps more pronounced in effect.

It remains different this time, and despite equities as an asset class not having been stretched in value and arguably inexpensive by historic standards, it remains difficult for me to rationalize having a fully or overweight position in stocks.

The tug of war between the rays of economic and profit recovery and the clouds of nontraditional depressants seem likely to remain in place for most of this year.

So, for now, in the halls of the New York Stock Exchange on Broad Street and outside in the streets of New York City, raindrops keep falling on our heads!