Juggling Dynamite

Vapid volumes courtesy of Algo traders surfing on central bank liquidity have driven most asset prices higher over the past two months. These price gains fly in the face of a weakening global economic outlook as forecasters slowly cut their previously optimistic projections for 2012 and 2013 global growth.  Today Pimco lowered its global growth forecast for 2013 to 1.3 percent to 1.8 percent from about 2 percent pointing out that the private sector isn’t healthy enough to step in and extend credit amid deleveraging and that Central banks are gradually losing effectiveness in helping the real economy, while the low growth rate of corporate profits and the low rate of investment means a near stall speed of the global economy in the months ahead.

In advanced economies, yields on both investment grade and sub-investment grade corporate bonds have fallen to their lowest levels since before the 2008 financial crisis. The same is true of yields on emerging market bonds, whether issued by sovereigns or corporates, denominated in local or international currencies. Yields on bonds backed by mortgages and other collateral have fallen to their lowest levels ever. Meanwhile, equity markets mostly rose. Both asset classes have benefited from more loosening of monetary policies and a consensus perception that major near-term downside risks to the world economy have magically diminished. As one after another commentator throws caution to the wind, I can’t help but remember that time old adage that when all of the experts agree, something else is bound to happen. These charts courtesy of the Bank for International Settlements capture the price risk in current stock and bond prices.

The NFIB Optimism Index shows job creation in November was essentially zero. William Dunkelberg, NFIB chief economist, offers insight. Here is a direct link.

John Hussman’s piece today is worth reading and offers valuable insight on the duration and peril prevalent in secular bear markets. See: Secular Bear Markets: volatility without return. It also reminds that there are cyclical opportunities where one can capture profits in equities at various points within secular bears. Timing these opportunities is everything however, and timing requires some luck and discipline–ideally a bit of both. The facts are that that blind hope aside, from present valuations, stocks are priced to achieve an average return over the next 5 years of something like 3% a year with huge volatility in a best case scenario, and -14.9% a year in a worst case scenario. Hussman explains the math:

“A bit of arithmetic is instructive here. Suppose that future economic growth remains similar to past growth, and normalized earnings grow by about 6% annually. Assume also that at some point, let’s say 12 years into the future, the Shiller P/E simply touches 10 – still above the 5-7 multiples reached in prior secular bears (excluding the bubble period since the late-1990’s, the historical norm for the Shiller P/E is less than 15). Given a dividend yield of 2.3%, and a present Shiller P/E about 21, we can estimate the 12-year prospective return on the S&P 500 on those assumptions at:

(1.06)*(10/21)^(1/12)+.023*(21/10+1)/2 – 1 = 3.2% annually.

As for the past 12 years, we started at a Shiller P/E of 44, moving to 21 at present, and began at a dividend yield around 1.2%. Our arithmetic indicates we should have observed an annual total return of about:

(1.06)*(21/44)^(1/12)+0.012*(44/21+1)/2 = 1.5% annually (Check. The actual return came in at 1.3%).

For optimists, assuming that the Shiller P/E falls no lower than 16, and not until 5 years from now, we would still expect a 5-year prospective total return of just 3.1% between now and that touch-point. For pessimists – or equivalently, for optimists that a secular bull market will begin sooner rather than later – a Shiller P/E of 7 reached 4 years from today would result in a prospective market loss of -14.9% annually over that 4-year period. There are certainly many intermediate possibilities, but unless one expects valuations to remain rich indefinitely, with no retreat to historically normal or undervalued levels as far as the eye can see, the eventual resolution of this period of secular overvaluation leaves little to be desired for long-term investors. I have little doubt that better opportunities will be available even over the course of the present market cycle.”

Hussman’s economic work agrees with ours, and others like Gary Shilling and the Economic Cycle Research Institute (ECRI), in the conclusion that the US very likely joined a global recession in the 3rd quarter of 2012. Once begun we know that during secular bear deleveraging periods, recessions tend to last 12 to 18 months. Over the past 100 years, 20% of the time stock markets have not followed the economy down but have continued to climb during a recession. 80% of the time however global stock markets have declined, with the S&P 500 losing an average of 25 to 45% of its value.

Lakshman Achuthan of Economic Cycle Research Institute, explained these odds in this recent clip. See here for a direct link.

So the question is what are thinking people to do in the face of these odds and how much does each of us wish to bank on best case scenario luck?

Most managers and advisers are wed to the theory of constantly buying and holding stocks in client accounts regardless of odds for success. In essence they are saying that regardless of the fact the recessions during secular bears are recurring and long and devastating to invested capital 80% of the time, they are going to direct all of their client chips on to the 20% chance for good luck. The reward for the client if such 1/5 odds pan out? Why the chance for that 3% gross annual return (Hussman’s best case math above) less any commissions and management fees paid. A ride that not only requires one to stay on the crazy train through each wild plunge and subsequent bounce back, but also requires that an investor can and will wait long enough to see their fortunes come round and round again within their required time horizon.

4/5ths of the time, holding stocks in this environment, will result in negative compound annual returns over a 15 to 20 year holding period. But 1/5th of the time, we might get away with a slightly positive gross return if we are able to stick with it long enough. Fair compensation? This is the question that every one of us has to answer for ourselves if allocating some of our life savings to equities today. How much do we want to bank on these odds?