Loyal readers can imagine that pulling together all of the concepts and editorials (not to mention all the 80s music videos) behind these missives is a time-intensive activity. Our efforts to share our most pressing prospective sometimes falls to the wayside, while we are acutely focused on managing risks and allocating capital. Needless to say, the past few months has been a good example of this as our writing has dwindled. Recognizing that we have yet to publish this quarter’s Broyhill Letter, and considering that I am leaving for Edinburgh this afternoon for the CFA Institute’s 64th Annual Conference, I thought I’d share a random collection of thoughts and images with our readers, to give you a sense of “where we are” today and “what we’re watching.” I look forward to sharing my impressions from the conference with you when I return. Until then, investors may wish to consider the following:
Cracks in the Rally
Our friends at Ned Davis have identified 10 rallies of 5% of more since the bull market began in March 2009. In each, leadership has been text-book, with cyclicals and commodities leading the market. At least until now. The current rally has seen a decisive change in character with health care, telecom, and staples among the market’s outperformers. Also, worth noting is the picture below from Francois Trahan which clearly shows that $4 gasoline is starting to take a toll on the consumer. The rally in early cyclicals relative to late stage cyclicals provided investors accurately identified the pending market rally in late 2008. The relative decline in these groups pointed to “double dip” fears in early 2010 and also confirmed the market’s excitement for QE2 later in the year. Again, this has changed. And rather abruptly at that. The sever underperformance of early cyclicals today was warning of weak economic data ahead months ago and continues to warn of a decline in economic growth later this year.
Inflation is all the Rage
Inflation is everywhere. Every investor we talk to is terrified about a declining dollar. Every company we speak with is worried about spiking input costs. Even friends who run local restaurants here in town have asked us how best to buy silver to hedge against a dollar collapse. Yet this chart, from KimbleChartingSolutions highlights a massive negative divergence. Charts don’t lie. Politicians do. And the charts are telling us exactly what we’ve been saying for years. In a highly indebted global economy, the immediate forces of an extended deleveraging process are deflationary. Take a look at recent comments from the world’s largest retailer. American’s don’t have money to spend on anything else, as long as they are paying $4 gallon to fill up their SUVs.
It’s worth noting that the last time we saw a spike in inflation expectations of this magnitude was H1-08, right before commodities collapsed. I’ve been saying for almost a year now, that higher commodity prices are ultimately deflationary within the context of a long term deleveraging process. The data support our thesis. When inflation expectations have spiked to levels this high, CPI has actually fallen at a 4.6% annual rate. Markets often move in a manner to prove the majority wrong. Consensus today is betting big on shorting dollars and shorting treasuries. We are setting up for another monster rally in both. The only question is the level from which it starts.
Faster Than a Speeding Bullet
Speaking of spikes in inflation expectations, we think the excerpt below from Bill Hester, CFA is worth a close look:
The topic of inflation tends to be a tool used by both sides of the debate about stock market performance. It’s argued that because corporations can pass on rising prices of raw goods to consumers, earnings will keep pace with inflation, so equities are a good hedge against inflation. It’s also argued that because the 1970’s was a terrible decade to own stocks, very high rates of inflation must be bad for equities. As in many discussions surrounding financial market topics, there is some truth in each of these arguments. But the full story tends not to lend itself to such broad generalizations.
Maybe one of the most underrated risks regarding inflation is the speed at which it is rising, even if that increase is off of a low base. It’s not high levels of inflation that precede important stock market declines, but instead how rapidly inflation is rising relative to its recent trend. And when you mix an overvalued market with rapidly rising inflation, bad outcomes tend to follow.
We can use the Producer Price Index to highlight this characteristic. The graph below shows each occurrence where inflation in the PPI Index was above 3 percent, the most recent PPI value was at least 60 percent above its 18-month moving average, and the cyclically-adjusted P/E ratio was above 16. For clarity, I’ve only displayed the first occurrence in any 12-month period. This set of conditions highlights periods where valuations were high (and therefore risk premiums are low) and producer inflation was rising at a fast pace relative to its recent trend.
It’s clear from the chart that periods following high P/E multiples and quickly rising rates of inflation haven’t worked out well for investors, on average. The worst instances came in December of 1965, three months prior to a 23 percent decline, in February 1973, a few weeks into a decline which would take stock markets down by half, in September 1987, and in September 1999 and October 2007, just prior to last decade’s two 50 percent-plus declines. The May 1989 instance was early, as the economy didn’t enter into a recession until the summer of 1990. But the market was mostly unchanged during this period, and would eventually fall by 20 percent. The one instance that was followed by gains came in July of 2003.
Extreme Conditions and Typical Outcomes
Bottom Line: Inflation is bad for stocks, at least until the market has fully discounted it. At 24x normalized earnings, this is a stretch. What’s worse than inflation, is the present set of conditions in the market today which are among the most extreme in history. According to John Hussman, the current set of conditions isn’t observed often, but the historical instances satisfying in post-war data are instructive. Here’s an exhaustive list of them:
- August 1972, November-December 1972: The S&P 500 quickly retreated about 5% from its August peak, then advanced again into to its bull market peak near year-end (about 6% above the August peak). The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.
- August 1987: The market advanced about 6% from its initial signal into late August. The S&P 500 then lost a third of its value within 8 weeks.
- June 1997: The only mixed outcome, during the strongest segment of the late 1990’s tech bubble. The S&P 500 advanced another 10% over the following 8 weeks, surrendered 4%, followed with a strong advance for several months, surrendered it during the 1998 Asian crisis, and then reasserted the bubble advance. Over a 5-year period, the overvaluation ultimately took its toll, as the S&P 500 would eventually trade 10% below its June 1997 level by the end of the 2000-2002 bear market. Still, the emergence of the internet, booming capital spending, strong economic growth and job creation, rapidly falling inflation, and dot-com enthusiasm evidently combined to overwhelm the negative short- and intermediate-term implications of this signal.
- July 1999: The S&P 500 advanced by 3% over the next two weeks, then declined by about 12% through mid-October, and after a recovery to the March 2000 bull market high, the S&P 500 fell far below its July 1999 level by 2002.
- March 2000: The peak of the bubble – the S&P 500 lost 11% over the following three weeks, recovered much of that initial loss by September, and then lost half its value by October 2002.
- May/June 2007, July 2007: The S&P 500 gained 1% from the late-May/early-June signal to the July signal, then lost about 10% through August 2007, recovered to a marginal new high of 1565.15 by October (about 1% beyond the August peak), and then lost well over half of its value into the March 2009 low.
- February 2011, April 2011: A cluster of signals in the 2-week period between February 8-22 immediately followed by a decline of about 7% over the next 3 weeks. As of Friday, the market has recovered to a marginal new high about 1.5% above the February peak.
So not including the cluster of signals we’ve observed in recent months, we’ve seen 6 clusters of instances in post-war data (we’re taking the 1997, 1999 and 2000 cases as separate events since they were more than a few months apart). Four of them closely preceded the four worst market losses in post-war data, one was quickly followed by a 12% market decline, and one was a false signal over the short- and intermediate-term, yet the S&P 500 was still trading at a lower level 5 years later. The red bars indicate instances of this syndrome since 1970, plotted over the S&P 500 (log-scale).
Piling Debt Upon Debt
What’s wrong with this picture? While stated Debt to GDP ratios rank at the top of investor concerns today, they do not even scratch the surface of developed world solvency issues. As shown by JPM, unfunded entitled obligations dwarf existing public debt at home and in Europe. We need leaders to “get real” and stop making empty promises at home. The good news is, we only have to fight amongst ourselves to reach an appropriate long term solution. What are the chances that the various egos and political constituencies across the EU can coordinate a comprehensive solution that appeases all of the individual sovereigns involved? Wolfgang Munchau of the FT provided the clearest response to our question. “A monetary union is at a natural disadvantage when it comes to the handling of crises. There is no central government that takes decisions, which makes communications hard to control. What is less forgivable is the serial incompetence of the Eurozone’s decision-makers, as exemplified by the perpetual eagerness to declare the crisis over the very second financial market pressure subsides. Not only do they know little about financial markets, they have surrounded themselves with policy advisers who know little too.”
Italy is headed for a double dip on our estimates. So is Spain. Although markets are pricing in a roughly 100% probability of a Greek default, while crises in Ireland and Portugal have intensified, credit pressures in Italy and Spain have stabilized relative to the three little pigs. With a hawkish ECB likely to choke off any hope of growth in the periphery, and additional downside risk coming from fiscal austerity, seems that the market’s current complacency is ill advised. Spain’s total Debt to GDP is at record highs and well above the EU average. Even beyond the obvious bubble in credit-fueled housing markets, Spanish companies are swimming in debt and barely breaking even, despite the current “recovery.”
Words Fail Me
Great chart below from Soc Gen’s Albert Edwards, which mirrors what we are seeing in various Economic Surprise Indices. Similar to the first chart we shared above, the change in analyst optimism has led turns in the economy and in stock markets since the beginning of the current (?) bull market in March 2009. As Albert says, “Post-bubble volatility will continue to surprise. This patch of stronger-than-expected economic data will inevitably subside with the demise of QE2. This is how it was in Japan after their bubble burst. Our most preferred leading indicators are already suggesting the turn is here.” Markets may have begun to sniff out the economic weakness ahead, as they have done over and over again throughout history. Or perhaps they are beginning to question whether or not risk assets will continue to levitate without the Fed’s daily bid, which is scheduled to conclude over the next few weeks. Coincidentally, this would coincide nicely with most of the cycle work we monitor. The Presidential Cycle should begin to run out of steam in the next few months. We are also entering a six-month period of negative seasonality from May through October, which has historically been even more troubling with leading indicators declining. Shorter term cycles point to a near-term top which would most likely be followed by a rally back to trend
to suck in the last of those on the sidelines, right before we kick off a fresh cyclical bear market.
And to top it all off, probably as good a sign of “capitulation” as any, is the fact that we’ve closed out nearly 20 short positions year-to-date and substantially reduced the gross exposure of the portfolio, at least until we see signs that the market is reconnecting with economic reality. Pending that reality check, we’ll just stick with our highest conviction ideas for now. We think David Einhorn – who apparently agrees with our Best Buy investment thesis (although we’ll agree to disagree on a certain Florida land company) – said it best in his recent quarterly letter, so I’ll make no attempt to edit his comments and will simply plagiarize instead – “Much like Charlie Sheen, who seems to believe that all publicity is good publicity, recent market behavior suggests that we are in the part of the cycle where ‘all news is good news’ . . . We expect to take some lumps when our shorts release strong earnings and their stock prices rise accordingly. Yet this quarter we were repeatedly confuzzled when we read company news announcements that we expect to cause falling stock prices, only to see them rise instead – and sometimes sharply at that . . . Nevertheless, we believe that this environment is cyclical, and that it will continue this way . . . until it doesn’t.”
Is “confuzzled” even a word? Perhaps my CFA colleagues in Scotland can tell me. Until then . . . .