S&P 500 1,552.50 +1.44%*
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BOTTOM LINE: Overall, last week's market performance was very bullish as the Dow, S&P 500 and Russell made new all-time closing highs. The NYSE cumulative advance/decline line rose, most sectors gained and volume was above average on the week. Measures of investor anxiety finished the week around average levels, despite the exceptional gains in stocks. The AAII percentage of bulls fell to 43.64% this week from 43.84% the prior week. This reading is at average levels. The AAII percentage of bears fell to 30.0% this week from 32.88% the prior week. This reading is also at average levels. These subdued readings come even as the DJIA is just off one of its most prolific winning streaks in history and hit a new all-time high Friday.
Moreover, the 10-week moving average of the percentage of bears is currently at 38.1%, a very high level. The 10-week moving average of the percentage of bears peaked at 43.0% at the major bear-market low during 2002. The 50-week moving average of the percentage of bears is currently 36.3%, an elevated level seen during only two other periods since tracking began in the 1980s. Those periods were October 1990-July 1991 and March-May 2003, both of which were near major stock market bottoms. The extreme readings in the 50-week moving average of the percentage of bears during those periods peaked at 41.6% on Jan. 31, 1991, and 38.1% on April 10, 2003. We are still very close to eclipsing the peak in bearish sentiment during the 2000-2003 market meltdown, which is astonishing considering the macro backdrop now and then.
I continue to believe that steadfastly high bearish sentiment in many quarters is mind-boggling for the following reasons:
· the 29.4% rise in the S&P 500 in a little over a year;
· the 111.5% gain (17.0% annualized) for the S&P 500 since the 2002 major bear market lows;
· a recent new record high for the NYSE cumulative advance/decline line;
· all market-caps and styles are participating;
· one of the best August/September/October market runs in U.S. history;
· the U.S. economy is accelerating with little chance of a Fed rate hike as most measures of inflation remain below long-term average rates; and
· we are in the early stages of what is historically a very strong period for U.S. equities after a midterm election.
As well, despite recent gains, the forward P/E on the S&P 500 is a very reasonable 16.5, right near where it began the year, due to the historic run of double-digit profit growth increases and better-than-expected earnings guidance in the first quarter. The S&P P/E multiple has contracted for three consecutive years. It has only contracted four consecutive years two times since 1905. Each point of multiple expansion is equivalent to a 6.6% gain in the S&P 500. I strongly suspect we will finally see expansion this year. The many bears still remain stunningly complacent, in my opinion.
As I have said many times over the past year, it seems every pullback is seen as a major top by the bears, and every move higher is just another shorting/selling opportunity. I see few signs of capitulation by the bears, and their ranks remain historically crowded given recent gains. Even most bulls seem to want the market to decline to redeploy cash they raised in anticipation of a meaningful correction. I still sense very few investors believe that the market has meaningful upside from current levels and are positioned accordingly. Investment manager performance anxiety is now likely elevated.
As well, there are many other indicators registering high levels of investor anxiety. The Yale School of Management Crash Confidence Index is showing the individual is currently the most concerned about a stock market crash since November 2002, right near the trough of one of the worst bear markets in U.S. history and the record-setting low for the index going back to 1989. The ISE Sentiment Index hit a low 101.0 on Thursday. The CBOE total put/call ratio 10-week moving average is currently 0.97, an above-average level.
Large speculators are the most net short the S&P 500 futures since June 2004, which corresponds with a recent Greenwich Associates hedge fund manager sentiment survey that registered 12% bulls, the lowest since 2004. SentimenTrader's All-Index, All-Product Dollar-Weighted Stochastic is at an extreme 99.2. Readings at or above 80 are historically followed by a 13.6% gain in the S&P 500 89% of the time on average over the next 12 months. Moreover, NYSE short interest has gone parabolic, soaring 30% the last four months, the largest four-month percentage jump on record, to another new all-time high. As well, Nasdaq short interest has surged an astonishing 30.2% over the last four months, also the largest four-month percentage increase on record, and also a new record high. Furthermore, public short interest continues to soar to record levels as odd-lot short sales recently spiked. This other chart from sentimenTrader.com shows U.S. stock mutual funds have seen outflows for most of the last year, according to AMG Data Services. The percentage of U.S. mutual fund assets in domestic stocks is still the lowest since at least 1984, when record-keeping began.
There has been an historic explosion of hedge funds created with absolute return, low correlation or negative correlation U.S. stock strategies that directly benefit from the perception of a stagnant or declining U.S. stock market and economy. One example is the equity Market Neutral hedge fund strategy, which has seen a massive infusion of capital since the bursting of the bubble in 2000, but has only returned an annualized 2.63% since June 2003 vs. a 14.0% annualized return for the S&P 500 over the same timeframe. The immense popularity of the market neutral strategy and other low-correlation U.S. stock strategies have been a huge contributing factor to the record explosion in short interest on the exchanges. How long will institutional and high net worth investors pay high fees for this type of risk-adjusted return and what will happen when they pull out and move into more positively correlated U.S. stock strategies?
As well, commodity funds, which typically have a low or negative correlation with stocks, have been created in record numbers. The Dow Jones-AIG Commodity Index has only returned 9.7% annualized over the last three years and 2.9% over the last year, during one of the greatest commodity manias in history, vs. a 12.2% annualized return for the S&P 500 over the same period. It seems to me many of the managers of these types of funds are all over major media outlets with their negative spin and pessimism. Moreover, many funds that directly benefit from a stagnant U.S. economy and stock market are becoming much more active politically.
Consumer confidence in the northern part of the country, where most major investment funds and media outlets are located, remains depressed near the 2000-2003 major bear market lows. A short-sighted, day-trading, pessimistic mentality has thoroughly permeated the investment landscape. Research boutiques with a negative bias have sprung up to cater to these many new funds that help pump air into the current U.S. "negativity bubble." In my opinion, only in a negativity bubble could numerous investors and analysts seriously suggest that the overwhelmingly pessimistic press is too optimistic.
Given the current historic pessimism with the DJIA at record highs, I suppose the many with a bearish agenda will only be happy when every last U.S. investor, reader and viewer are permanently driven away from stocks. Permabears, or "fearleaders," are still more widely followed than ever, despite the market's triple-digit percentage gain from the major bear-market lows. At this major market bottom, permabulls, or "cheerleaders," had been shunned and chastised for a couple of years. Wall Street analysts have made the fewest buy calls on stocks this year since Bloomberg began tracking in 1997. Buy calls have been trending lower for over a year, despite the huge rally in stocks.
According to TickerSense.com, investment blogger sentiment remains pessimistic at 36.0% bears vs. 32.0% bulls. The UltraShort QQQ ProShares (QID) continue to see soaring volume. There is still a very high wall of worry for stocks to climb substantially from current levels as the public and many professionals remain very skeptical of this bull market and continue to trade with one foot out the door.
I still believe this is a direct result of the strong belief by the “herd” that the U.S. is in a long-term trading range, or secular bear environment, notwithstanding recent outsized gains. There is overwhelming evidence that overall investment sentiment regarding U.S. stocks has never been this poor in history, with the Dow at an all-time high. I still expect the herd to finally begin to embrace the current bull market this year, which should result in another substantial move higher in the major averages. I still expect the S&P 500 to return a total of around 17% for the year, however this projection is looking conservative at this point.
It's hard to believe that, after the bombardment of pessimism, depression comparisons and crash calls that occurred in March, the average U.S. stock is still doing very well this year. The Value Line Geometric Index, the best gauge of the broad market, is 10.8% higher year-to-date. Moreover, it is interesting to note that mid-cap “growth” stocks are sporting a gaudy 15.6% gain already this year, which is the best of any equity style. Notwithstanding the extreme pessimism for U.S. stocks by many investors, corporate insider activity is closer to levels normally associated with market bottoms than tops. Based on the action over the last few months, even more cash has piled up on the sidelines as money market funds reported this week that assets set another record.
I continue to believe that a significant portion of this cash will be deployed into true growth companies as their outperformance vs. value stocks gains steam throughout the year. I am already seeing signs that this is starting to happen. As well, Chinese investors may be a new source of demand for U.S. stocks. There is massive bull firepower on the sidelines at a time when the supply of U.S. stocks is still shrinking, which makes for a lethally bullish combination. I still believe the coming bullish shift in long-term sentiment with respect to U.S. stocks will result in the "mother of all short-covering rallies."
The average 30-year mortgage rate rose 10 basis points this week to 6.73%, which is 7 basis points below July 2006 highs. There is still mounting evidence that the worst of the housing downturn is over, despite recent worries over sub-prime lending, and that sales activity is stabilizing at relatively high levels. Even after the recent slowdown, existing home sales are still 10.3% above the peak during the late-90s stock market bubble. About 14% of total mortgage loans are sub-prime. Of those 14%, another 13.77% are delinquent. Thus, only about 2% of total mortgage loans outstanding are currently problematic. I still don’t believe sub-prime woes are nearly large enough or will become large enough to meaningfully impact the prime market and bring down the U.S. economy. Furthermore, US economic growth likely accelerated substantially last quarter to a 3%+ rate.
The Fed’s Bernanke said recently that the prime market is still strong and that he sees no spillover from the sub-prime problems. As well, the Fed’s Poole said recently that, “there is no danger to the economy from sub-prime loan defaults.” There are just too many other positives that outweigh this negative. Treasury Secretary Paulson reiterated his belief that all the signs he looks at lead him to conclude housing is near or at the bottom. The Fed’s Warsh said this week that sub-prime losses “aren’t posing systemic risk problems.” Moreover, the Fed’s Hoenig, Lacker, and Plosser all made positive comments recently regarding the prospects for the US housing market.
Mortgage applications rose 1.1% this week and continue to trend higher with the rising stock market and healthy job market. Furthermore, home purchase applications jumped 3.8% this week and the 10-week moving average of purchase applications is at the highest level in 17 months. The Mortgage Bankers Association reiterated recently that the US housing market will “fully regain its footing” by year-end. Finally, the House Price Index actually rose .5% in the first quarter, despite recent worries.
The Housing Sector Index(HGX) has risen 16.6% from July 2006 lows. Moreover, rumors surfaced this week that billionaire investor Warren Buffett is accumulating a large stake in homebuilder Hovnanian Enterprises(HOV). The Case-Shiller home price futures have improved and are now projecting only a 1.8% decline in the average home price through November, up from projections of a 4.0% decline 4 months ago. Considering the median house has appreciated over 50% during just the last few years with record high US home ownership, this would be considered a “soft landing.” Furthermore, the Case-Shiller Home Price Index is 127.3% higher over the last decade.
I continue to believe the many U.S. stock market bears are exaggerating, in every media outlet possible, the overall impact of housing on the economy in hopes of scaring investors, consumers and the government into a panicked state, thus making the problems worse than would otherwise be the case. Some large funds are benefiting greatly from the sub-prime housing pain. Housing activity and home equity extractions had been slowing substantially for over 2 years and the negative effects were mostly offset by many other very positive aspects of the US economy.
Home values are more important than stock prices to the average American, but the median home has barely declined in value after a historic run-up, while the S&P 500 has risen 29.4% over the last year and 111.5% since the Oct. 4, 2002 major bear market low. Americans’ median net worth is hitting new record high levels as a result, a fact that is generally ignored or minimized by the record number of stock market participants that feel it is in their financial and/or political interests to paint a bleak picture of America.
Moreover, unemployment is low by historic standards, interest rates are low, inflation is below average rates and wages are rising at above-average rates. The economy has created about 2 million jobs in the last year. As well, the Monster Employment Index just recently hit another record high in May. The 50-week moving average of initial jobless claims has been lower during only two other periods since the 70s. Finally, the unemployment rate is a historically low 4.5%, down from 5.1% in September 2005, notwithstanding fewer real estate-related jobs and significant auto production cutbacks. The unemployment rate’s current 12-month average is 4.6%. It has only been lower during two other periods since the mid-50s.
The Consumer Price Index for May rose 2.7% year-over-year, down from a 4.7% increase in September of 2005. This is below the 20-year average of 3.1%. Moreover, the CPI has only been lower during four other periods since the mid-1960s. Most other measures of inflation are still below long-term average rates. The Fed’s preferred inflation gauge, the PCE Core, rose 1.9% year-over-year in May versus the 20-year average of 2.5% and is now within the Fed’s comfort zone. Furthermore, most measures of Americans’ income growth are now almost twice the rate of inflation. Americans’ Average Hourly Earnings rose 3.9% year-over-year in June, substantially above the 3.2% 20-year average. The 11-month moving-average of Americans’ Average Hourly Earnings is currently 4.04%. 1998 was the only year during the 90s expansion that it exceeded current levels.
The benchmark 10-year T-note yield fell 8 basis points for the week on less hawkish Fed commentary and sub-prime worries. According to Intrade.com, the chances of a US recession beginning this year have plummeted to 9.2% from 35% in January. In my opinion, many investors’ lingering fears over an economic “hard landing” still seem misplaced. The housing slowdown and auto-production cutbacks impacted manufacturing greatly over the last year, but those drags on growth are subsiding.
For all of 2006, US GDP growth was an above-average 3.2%, notwithstanding housing and manufacturing headwinds. Moreover, many gauges of manufacturing activity have improved meaningfully over the last couple of months. The 4-month average of Factory Orders is at the highest level since late 2005. The Chicago PMI has exceeded a booming 60 three of the last four months. Finally, the ISM Manufacturing index has registered expansion for five consecutive months and at 56.0 is currently above the 20-year average of 52.4.
While the drag from housing is subsiding, housing activity will not add to economic growth in any meaningful way this year as homebuilders continue to work down inventories and sales stabilize at lower, but still relatively high by historic standards, levels. As I said during the 1Q slowdown, I expect a smaller GDP deflator, inventory rebuilding, rising auto production, increased business spending and a still healthy service sector to boost US economic growth back to around 3% on average through year-end.
Manufacturing accounts for roughly 12% of US economic growth, while consumer spending accounts for about 70% of growth. U.S. GDP growth came in at a sluggish 1.1% and 0.7% during the first two quarters of 1995. During May 1995, the ISM Manufacturing Index fell below 50, which signals a contraction in activity. It stayed below 50, reaching a low of 45.5, until August 1996. During that period, the S&P 500 soared 31% as its P/E multiple expanded from 16.0 to 17.2. This was well before the stock market bubble began to inflate. As well, manufacturing was more important to overall US economic growth at that time. Stocks can and will rise as P/E multiples expand, even with more average economic and earnings growth.
Weekly retail sales rose 1.4% last week vs. a 1.6% gain the prior week. The job market remains healthy, overall housing has improved modestly, wage growth has accelerated, stocks are substantially higher and inflation has decelerated to below average rates. These positives continue to more than offset the negatives from housing and high gas prices. Consumer confidence jumped this month by the most since October of last year. Finally, I expect both main measures of consumer confidence to make new cycle highs over the intermediate-term as energy prices fall significantly, unemployment remains historically low, wages continue to substantially outpace inflation, stocks rise further, home sales stabilize at relatively high levels, inflation decelerates more and interest rates head back down. This should also help boost consumer spending back to above average rates this fall.
Just take a look at commodity charts, gauges of commodity sentiment and inflows into commodity-related funds over the last couple of years. Net assets invested in the Goldman Sachs Commodity Index rose to almost $70 billion in 2006 from $15 billion in 2003. There has been a historic mania for commodities by investment funds that has pushed prices significantly higher than where the fundamentals dictate. That mania is now in the early stages of unwinding. The CRB Commodities Index, the main source of inflation fears has declined -8.7% over the last 12 months and -11.0% from May 2006 highs despite a historic flood of capital into commodity-related funds and numerous potential upside catalysts. This year oil plunged $12/bbl. over the first 18 days of trading at the beginning of the year. Last year, oil rose $2.05/bbl. on the first trading day of the year and $7.40/bbl. through the first three weeks of trading as commodity funds, flush with new capital, drove futures prices higher.
I suspect, given the average commodity hedge fund fell around double-digits last year as the CRB Index dropped -7.4% and that the average commodity hedge fund is just marginally higher this year, that many funds are seeing significant redemptions. Recent reports have indicated that institutional investors are switching from commodity funds that trade energy futures to hedge funds that buy energy-related equities. The commodity mania has also pumped air into the current US “negativity bubble.” Talk of runaway inflation, drought, world wars, global warming, a US dollar collapse, recession/depression and global pandemics, to name a few, has been fueled by the mania for commodities. In my opinion, that is why it is so easy for most to believe that US housing was in a bubble, but then act shocked when commodities plunge. I continue to believe inflation fears have peaked for this cycle as global economic growth slows to more average levels, the US dollar firms, unit labor costs remain subdued and the mania for commodities continues to reverse course.
The EIA reported this week that gasoline supplies rose more than expectations even as refineries remain very slow to come back online after a recent historical rash of “outages.” Refinery utilization is currently 90.2%, a 15-year low for this time of the year and below levels seen in the same week of 2006 after the historic hurricanes in 2005 destroyed energy infrastructure in the Gulf of Mexico. Furthermore, notwithstanding complaints from refiners that they have not been allowed to build a new refinery in over three decades, refiners actually killed plans within the last year to increase production by 500.000 barrels per day due to worries over “future gasoline demand” and “high costs.”
Gasoline futures fell for the week as supplies rose even with extraordinarily low refinery utilization. Gasoline futures are still down 23.5% from September 2005 highs. The gasoline crack spread fell this week, but remains near levels seen during hurricane Katrina’s aftermath. It is interesting to note that crack spreads peaked last August right before oil plunged $28/bbl. in less than six months. It is also interesting to note that commercial hedgers, historically the “smart money”, are the most net short oil they have been in at least seven years, notwithstanding the recent historic spike in crack spreads, which is highly unusual. Temporary refinery “outages” are still helping to prop up the entire energy complex. However, the very elevated level of current gas prices will only further dampen global fuel demand, sending gas prices substantially lower over the intermediate-term.
The 10-week moving-average of US oil inventories is now near a 10-year high, as well. Oil consumption in the 30 OECD countries fell last year for the first time in over two decades, while global economic growth boomed 5.3%. Global demand destruction is pervasive. Over the last three years, global oil demand is only up 2.4%, despite the strongest global growth in almost three decades, while global supplies have increased 5.0%, according to the Energy Intelligence Group. The EIA recently forecast that bio-fuels should rise to the equivalent of more than five million barrels of crude oil production a day within four years. As well, Energy Secretary Bodman said the US will likely remove tariffs to boost bio-fuel imports, which should reduce fears over a potential corn shortage over the long-term. Sugar, which was touted as “the new oil” by several well-known commodity bulls, has collapsed -50.0% since February of last year.
As well, worldwide oil inventories are poised to begin increasing at an accelerated rate over the next year. There is a very fine line in the crude oil market between perceptions of "significantly supply constrained" and "massive oversupply." One of the main reasons I believe OPEC has been slow to actually meet their pledged cuts has been the fear of losing market share to non-OPEC countries. Moreover, OPEC needs lower prices badly to prevent any further long-term demand destruction. I continue to believe oil is priced at elevated levels on record speculation by investment funds, not the fundamentals.
The Amaranth Advisors hedge fund blow-up last year was a prime example of the extent to which many investment funds have been speculating on ever higher energy prices through futures contracts, thus driving the price of the underlying commodity to absurd levels for consumers and businesses. This is considered “paper demand”, which is not real demand for the underlying commodity. Amaranth, a multi-strategy hedge fund, lost about $6.5 billion of its $9.5 billion under management in less than two months speculating mostly on higher natural gas prices. I continue to believe a number of other funds will experience similar fates over the coming months after managers “pressed their bets” in hopes of making up for recent poor performance, which will pressure energy prices as these funds unwind their leveraged long positions to meet rising investor redemptions over the intermediate-term. Moreover, the same rampant speculation that has driven the commodity mania will work against energy as downside speculation increases and drives down prices even further than the fundamentals would otherwise dictate.
Cambridge Energy Research, one of the most respected energy research firms in the world, put out a report late last year that drills gaping holes in the belief by most investors of imminent "peak oil" production. Cambridge said that its analysis indicates that the remaining global oil base is actually 3.74 trillion barrels, three times greater than "peak oil" theory proponents say and that the "peak oil" theory is based on faulty analysis. The substantial contango that had existed in energy futures, which encouraged hoarding, has begun to meaningfully reverse as more investors are coming to the realization that the "peak oil" theory is hugely flawed, global crude storage tanks fill and expectations for a further deceleration in Chinese/US demand rise. December 2014 crude oil futures are now $1/bbl. below the current spot price.
Global crude oil storage capacity utilization is running around 98%. OPEC production cuts have resulted in a complete technical breakdown in crude futures, despite the recent move higher. Spare production capacity, which had been one of the main sources of angst among the many oil bulls, rises with each OPEC cut. As well, demand destruction which is already pervasive globally will only intensify over the coming years as many more alternative energy projects now in the pipeline come to the fore. Moreover, many Americans feel as though they are helping fund terrorism or hurting the environment every time they fill up their gas tanks. I do not believe we will ever again see the demand for gas-guzzling vehicles that we saw in recent years, even if gas prices plunge further from current levels, as I expect. If OPEC actually implements all their announced production cuts, with oil still at very high levels and decelerating global growth, it will only further deepen resentment towards the cartel and result in even greater long-term demand destruction.
I continue to believe oil made a major top last year during the period of historic euphoria surrounding the commodity with prices above $70/bbl. and calls for $100/bbl. oil commonplace. Even during the peak of anxiety in the recent Iranian/UK hostage stand-off, oil only rose about $6/bbl., despite renewed calls from numerous traders, analysts and pundits for $100+/bbl. oil. A large double-top technical formation is likely now forming in the commodity. Falling demand growth for oil in emerging market economies, an explosion in alternatives, rising global spare production capacity, increasing global refining capacity, the complete debunking of the hugely flawed "peak oil" theory, a firmer U.S. dollar, less demand for gas guzzling vehicles, accelerating non-OPEC production, a further reversal of the "contango" in the futures market, a smaller risk premium and essentially full global storage should provide the catalysts for oil to fall to $40-$45/bbl. later this year. I fully expect oil to test $20-$25/bbl. within the next three years as the historic investment fund speculation that has been propping up the commodity reverses course as fundamentals deteriorate further.
Natural gas inventories rose more than expectations this week. However, prices for the commodity increased even with supplies now 16.6% above the 5-year average and near all-time high levels for this time of year. Furthermore, the EIA recently projected global liquefied natural gas production to soar this year, with the US poised to see a 34.5% surge in imports and another 38.5% increase in 2008. Natural gas prices have collapsed -57.8% since December 2005 highs. Notwithstanding this severe decline, natural gas anywhere near current prices is still ridiculous with absolute inventories poised to hit new records this year. The long-term average price of natural gas is $4.63 with inventories much lower than current levels.
Gold rose modestly on the week as concerns over emerging markets’ demand continued to subside and the dollar declined. Perceptions of emerging market demand for the metal seem to be the greatest determinant of prices at this point. Copper rose on more US economic optimism and short-covering, despite an 11% surge in Shanghai copper inventories. Copper is now -12.0% lower from the euphoric highs set last year. I continue to believe the recent bounce in copper has run its course and any substantial rallies from current levels should be sold. Natural gas, oil, gold and copper all look both fundamentally and technically weak longer-term. The US dollar fell for the week on increasing downside speculation, less hawkish Fed commentary and sub-prime worries.
I continue to believe there is very little chance of another Fed rate hike anytime soon, notwithstanding the recent acceleration in economic activity. An eventual rate cut is still more likely this year as inflation continues to decelerate substantially. The recent rise in mortgage rates will likely mute the rebound in housing and prevent the overall economy from growing too fast. As well, the substantial inventory rebuilding that took place last quarter will likely subside this quarter.
The US budget deficit is now 1.5% of GDP, well below the 40-year average of 2.3% of GDP. As well, the trade deficit has been trending lower over the last nine months. I continue to believe foreign investors’ demand for US securities will remain strong. Recent data shows a meaningful up-tick in international investors’ demand for US stocks. Energy stocks outperformed for the week on more US economic optimism, higher oil prices and stock buyback announcements. Airline stocks underperformed on the rise in energy prices and negative analyst commentary.
Current US stock prices are still providing longer-term investors very attractive opportunities, in my opinion. In my entire investment career, I have never seen many of the best “growth” companies in the world priced as cheaply as they are now relative to the broad market. By contrast, “value” stocks are quite expensive in many cases. A CSFB report late last year confirmed this view. The report concluded that on a price-to-cash flow basis growth stocks are cheaper than value stocks for the first time since at least 1977. Almost the entire decline in the S&P 500’s p/e, since the stock market bubble burst in 2000, is attributable to growth stock multiple contraction. Many “value” investors point to the still “low” price/earnings ratios of commodity stocks, notwithstanding their historic price runs over the last few years. However, commodity equities always appear the “cheapest” right before significant price declines. I do no believe that “it is different this time.” I still expect the most overvalued economically sensitive and emerging market stocks to underperform over the intermediate-term as the manias for those shares subside as global growth slows to more average rates.
The emerging markets’ mania, which has mainly been the by-product of the commodity mania, is likely nearing an end, as well. The Financial Times reported recently that China's pollution problem is rapidly worsening on their soaring investments in energy-intensive industries. According to the FT, China now accounts for almost half of the world's flat glass and cement production, more than one-third of steel output and 28% of global aluminum production.
In my opinion, China is building for the sake of building, such as the world's largest mall, to promote the appearance of even more exceptional growth than would otherwise be the case. Massive overcapacity is being created in China. This is giving a false sense of demand for most of the world's commodities. This is the main reason why I believe long-term interest rates remain exceptionally low. I continue to believe when the manias for emerging markets and commodities end, the mild bout of inflation we have experienced globally will turn into a mild bout of deflation. The iShares Lehman 20+ Year Treasury Bond (TLT) remains a core long position for me as I firmly believe the secular trend of disinflation remains in tact.
The Shanghai Composite’s recent performance mirror’s that of the Nasdaq during the late 90s bubble. I am also keeping a close eye on the Vietnam Stock Index(VNINDEX), which has dwarfed the Nasdaq’s meteoric rise in the late 90s, rocketing 308.0% higher over the last 24 months. It is 35.9% higher just this year. The bursting of these bubbles, may well signal the end of the mania for all emerging market stocks. I continue to believe a chain reaction of events has already begun that will result in a substantial increase in demand for US equities by global portfolio managers.
S&P 500 profits have risen at double-digit rates for 19 consecutive quarters, the best streak since recording keeping began in 1936. Moreover, second quarter estimates are for a conservative 4.4% increase, which should be handily exceeded once again. Notwithstanding a 111.5% total return(which is equivalent to a 17.0% average annual return) for the S&P 500 since the October 2002 bottom, its forward p/e has contracted relentlessly and now stands at a very reasonable 16.5. The 20-year average p/e for the S&P 500 is 23.0.
In my opinion, the US stock market continues to factor in way too much bad news at current levels. One of the characteristics of the current US “negativity bubble” is that most potential positives are undermined, downplayed or completely ignored, while almost every potential negative is exaggerated, trumpeted, obsessed over and promptly priced in to stock prices. “Irrational pessimism” by investors has resulted in a dramatic decrease in the supply of stock. Moreover, booming merger and acquisition activity and giant corporate stock buybacks are also greatly constricting supply. Many commodity funds, which have received a historic flood of capital inflows over the last few years are now seeing redemptions as the CRB Index continues to languish, while the S&P 500 flourishes. Some of this capital will likely find its way back to US stocks. As well, money market funds are brimming with record amounts of cash. As I said above, there is massive bull firepower available on the sidelines for US equities at a time when the supply of stock has contracted.
A recent Citigroup report said that the total value of U.S. shares dropped last year, despite rising stock prices, by the most in 22 years. Last year, supply contracted, but demand for U.S. equities was muted. Despite recent stock gains US stock mutual funds are still seeing outflows. Keeping the public excessively pessimistic on U.S. stocks has been one of the many bears’ main weapons. However, I still suspect accelerating demand for U.S. stocks, combined with shrinking supply, will make for a lethally bullish combination over the intermediate-term.
Considering the overwhelming majority of investment funds failed to meet the S&P 500's 15.8% return last year, I suspect most portfolio managers have a very low threshold of pain this year for falling substantially behind their benchmark once again. Investment manager performance anxiety is likely quite elevated already this year as the major averages are on pace to exceed last year’s gains. The fact that last year the US economy withstood one of the sharpest downturns in the housing market in history and economic growth never dipped below 2% and averaged 3.2% illustrates the underlying strength of the US economy as a whole. While significant inventory de-stocking led to a mid-cycle slowdown, I suspect inventory rebuilding to added to economic growth last quarter, helping to boost growth substantially higher than the sluggish pace of the first quarter. Growth this quarter is likely to decelerate back slightly to below trend as the effects of the recent surge in mortgage rates take hold and inventory rebuilding subsides. However, above trend growth is likely again in 4Q.
I continue to believe the historically extreme readings in many gauges of investor angst during the last few months indicated the US market was cleansing itself of “weak hands” at an extraordinarily rapid rate. Buyout/merger speculation, a stronger US dollar, lower commodity prices, election cycle strength, decelerating inflation readings, a pick-up in consumer spending, lower long-term rates, increased consumer/investor confidence, short-covering, investment manager performance anxiety, rising demand for US stocks and the realization that economic growth is poised to rise around average rates over the intermediate-term should provide the catalysts for another substantial push higher in the major averages as p/e multiples expand significantly. I still expect the S&P 500 to return a total of about 17% for the year. However, this prediction is looking conservative at this point. "Growth" stocks are now leading the broad market higher. Mid-cap “growth” stocks are this year’s best-performing style, sporting a gaudy 15.6% return so far this year. The Russell 1000 Growth iShares(IWF) will likely rise a total of 25% for the year and continue to outperform over the long-run. Finally, the ECRI Weekly Leading Index rose to another new cycle high this week and is forecasting healthy US economic activity. The 10-week moving average of the ECRI Weekly Leading Index also hit a new cycle high, while the Future Inflation Gauge is declining at a -2.7% rate.
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