Stocks….the Odd Man Out

The S&P500 paused ever so briefly last week, losing 0.38% on slightly elevated volume. Volatility slipped back down to multi-year lows. The VIX index ended the week in the 13 point range, levels usually associated with extreme complacency. What can go wrong?

Well the economies of the world, and lately even that of the US, are in fact “going wrong”. Global PMI’s are plunging. Half the eurozone is already in recession. France and even Germany are set to follow. China is in middle of a hard landing and Japan’s economy has been stuck in a perpetual recession for the last 20+ years, and it’s still stagnating. To top it off, global trade flows are plunging. Exports of finished goods from Asia and imports of raw materials from Australia, Canada, Brazil and Africa are falling.

And even the US economy is faltering, with unemployment edging higher, ISM’s and PMI’s all stalling or falling, and regional Fed surveys in bad shape. Most recently, initial unemployment claims have started creeping back up toward the 400 thousand mark often associated with recessions.

On top of the grim economic news, corporate sales and earnings are BOTH falling….for the first time since the beginning of the Great Recession back in late 2007 and early 2008. Global shipping firms such as Fed Ex have warned several times that volumes are dropping. Other globally connected firms such as Intel have also toned down, dramatically, revenue and earnings expectations. And the list of corporate disappointments goes on and on.

So the extraordinary corporate profitability (as a percentage of sales) which just reached record high levels looks like it’s set to correct. And why have corporate profits soared, as unemployment remained stuck in the doldrums? Because the US government stepped in to fill the void—via transfer payments—to the tune of 1.5 trillion annual deficits for almost four years running. The problem is that on January 1, 2013 the US fiscal stimulus is set to go into reverse. The looming “fiscal cliff” if fully implemented could slash up to 5% of US GDP, which would cause corporate sales and profits to tumble….badly.

But stock prices (and yes, admittedly other financial asset classes such as high yield) have entered a world of their own. While the rest of world is grinding to a halt, if not into an outright decline, stock prices are continuing on their merry way…..higher.

This sets up one colossal test: either stock prices are correct and the global economic problems will promptly “fix” themselves, OR stock prices are wrong and will sooner or later get “fixed” themselves by dropping back down to earth, or reality.

In the meantime, the P/E multiple of the market is ballooning. Not only is it now several points higher than it was a year ago, but using the Shiller 10 year earnings P/E, the multiple for the S&P is back up to about 23 times…..a lofty level almost always associated with very POOR prospective returns and very HIGH risk.

Does this mean that a big correction is necessarily around the corner? Of course not. But it does mean that buying stocks now—ie. increasing allocations to equities—will almost assuredly lock in low returns (if not outright losses) and stomach churning volatility over a longer term holding horizon.

That’s most certainly NOT what most folks think they’re signing up for when they invest in stocks.

The key success factor is patience. Being patient by waiting for times when buying risk assets is favorable—being patient by not buying at times when prospective risk and return outlooks are unfavorable… they are today.

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