22 February 2013

Debate over S&P 500

There is lots of guessing and analysis being done in the financial communities when it comes to forecasting S&P 500 index, ticker symbols: ^GSPC (Yahoo! Finance), INX (Google Finance), and $SPX (MarketWatch). Opinions range from one extreme to another: I have seen targets as high as 1,735 by the end of 2013, as well as “doomsday predictions” suggesting the level of 1,040. These compare to the current (21 Feb 2013) number around 1,500. Below is a non-comprehensive summary of the debate, complemented with comments and opinions from my side.

For the starters, just when looking at the annual percentage changes in the index value, a 20% up by the end of 2013 seems as likely as a 20% down. So following the lines of arguments is rather interesting.

Why up?

The slogan has been: “Don’t fight the Fed.” Each of its QE rounds (QE1, QE2 and QE3) has resulted in a jump upwards before crashed by bad news, see the figure below. Up to very recently, Fed has sounded fully committed to continue with its ultra-easy monetary policies until unemployment remains above its defined threshold level of 6.5%. Considering the current trend of job creation in the US, this commitment may well mean “money printing” until the end of 2018, coincided with the super-low interest rates and an increase of the Fed’s balance sheet from the current level of USD 3 trillion to the level of USD 9 trillion when assuming bond purchases at the unchanged rate (calculations are by the economists in SEB Economic Research).

Technical analysts are drawing encouraging charts like the one below. This particular target level of 1,735 by Charles Cap LLC is based on the estimated earnings of about $113 per share for the S&P 500, and a 15.35X multiple. (Comment: the multiple 15.35 is slightly below the all time average cyclically adjusted P/E ratio but above the 13.5 figure that in the opinion of the others might accompany the earnings level of $113 per share in 2013; $113, the consensus earnings estimate of the bottom-up analysts, is 13% up from the approximate value of $100 for 2012 which top-down analysts think is high.)

Since interest rates for the (perceived) safe bonds are standing at near zero levels and deposits earn nothing or negative rates, retail investors are now coming to the market (despite of the warnings of some strategists); the flows into equity funds are once again positive – at least they were before Fed disclosing the FOMC’s 29-30 January meeting minutes on February 20 which revealed the discussions over risks from Fed's bond purchases. As a result, stock market volatility is at record lows even after having jumped in response to the referred minutes; for an illustration, see the graph of VIX, the S&P500 volatility index below. As argued, this low volatility has historically been followed by strong returns (even if not up from the current height of 30,000 feet!).

Why down?

Well, the continuing good performance of the market indices is not that sure given the market sentiment, let alone fundamentals.

First about the sentiment: the Crash Confidence Index by the Yale School of Management is indicating that the confidence of not having a stock market crash in the succeeding six months is not that high when put into historic perspective – just around the downward-trending average (see the next figure).

Even if market optimists are right in the sense that the cyclically adjusted P/E ratios are currently nowhere near the peak levels of the technology boom in the late 1999 / early 2000 (see the next figure, current 22.77 when compared to the 40+ during the height of the boom) and thus the stocks have considerable upwards potential, appropriate interpretations of the P/E ratios are most probably being missed by them.

As the top-down big picture analysts are implying, it’s not that the P/E ratio would further increase because of the rising stock prices if it were bound to do so given the trend or whatever. No, it would do so rather because of the declining earnings. Their main argument is illustrated in the next chart: as a percentage of GDP, wages are all-time low (blue line) while corporate profits are all-time high (red line). They are suggesting that corporate profit margins will eventually mean revert (which, as you see, has been the case in the past).

Note: Red line indicates the ratio of corporate profits to GDP in the US, and blue line respectively the ratio of wages to GDP

What is holding up corporate profits? At the end of the day, someone has to buy products and services that the companies are offering for sale. So it’s consumption.

It is being pointed out that government transfer payments are still holding up nearly 20% of total consumer spending (source: Hussman Funds, Mar 2012). How long this can possibly continue given the one-point-something trillions hole in the government’s annual budget that needs to be cut a lot for the US to stay (at least in the eyes of creditors) creditworthy? Not for long, as you might guess. The need to cut deficit also has a reducing effect to the government’s spending and/or results in higher taxes and less disposable income for the people.

Forget about consumption boost as a result of the declining unemployment rate, officially being reported as having fallen from around 10% in 2010 to 8.1% in the end of 2012. If the labour force participation rate would have remained to the 2010 level, unemployment rate would still be at 9.5% today, i.e. virtually no decline at all (which clearly makes us questioning the Fed targeting unemployment – it appears to have no tools whatsoever for achieving that target).

The one major issue however is the still growth-dragging over indebtedness. It hasn’t disappeared despite of all the talks about deleveraging that arguably has taken place already. Reportedly, almost 14 million homeowners in the US owed more on their mortgage than their homes were worth as of at the end of 2012; collectively they were underwater by $1 trillion in 2012. Student loan defaults are skyrocketing. Public sector should somehow reduce its debts by at least $3.5 trillion for returning to more-less sustainable levels. And don’t even mention the financial sector and the creative U.S. accounting rules. Just quoting Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp. via Bloomberg: “U.S. Banks Bigger Than GDP as Accounting Rift Masks Risk” – using international standards for derivatives and consolidating mortgage securitizations, JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. would double in assets, while Citigroup Inc. would jump 60 percent based on Q3 2012 data. In other words: reported debt burdens may seem huge, but even bigger amounts have “escaped” accounting so far.

This kind of top-down approach and basing forecasts on macro data may sound superficial when compared to bottom-up analysis but it DOES matter more than one might expect. Consider how sharply S&P 500 dropped after the Fed’s publication of the above referred January 29-30, 2013 FOMC minutes: from 1,530 to less than 1,500 with no time (not exactly a crash, but the message, if any, wasn’t strong either: just a slight cause of concern). Weak macro makes sky-high stock market valuations particularly vulnerable.


Probably my conclusion has been obvious from the above text: I personally tend to believe that the market is being held up by the illusions and fake promises by certain groups of interest rather than anything else. In my view, data and facts about the fundamentals are not supporting higher S&P 500 which means that any “bad news” can easily bring us to the negative territory. Some of the “bad news” has started to surface already. More is in the pipeline... but that’s a topic for another story. What I just said, doesn’t exclude the possibility for dead cat bounces given the way financial markets operate. Alternatively, there had to be a lot of “money printing” indeed for driving indices further up.

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