Saturday, July 20, 2013

2013 Second Half Outlook: U.S. Stock Market Decline Coming

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

It has been hidden from the eyes of the casual market observer, but since 2007 we have seen major tops in almost every major financial market on the planet. Many residential real estate markets topped in 2006, most commodities topped in 2008 (some in 2011), bonds peaked in 2012 (some in June 2013), and most stock markets around the world have not regained their highs seen in 2007.

In reality, we have seen a period of rolling tops and money has moved not with all asset classes pushing them higher, but focusing on one asset class that bursts higher and then fades. Where is this current focus of intense speculation?

The United States stock market.

The US stock market has become the new darling investment choice for investors almost everywhere you turn. You have heard that "there is no other option" or that the "great rotation" is here, two topics we discussed in a bonus section of the 2013 Second Half Outlook:

Bonus Section: The Great Rotation Meets No Other Alternative

Now we have heard that we are back in a Goldilocks scenario. The great David Tepper has come on CNBC during 2013 and told a mesmerized audience that stocks cannot fall for two very basic reasons:

1. The economy will improve which will push stocks higher
2. The economy will slow which will increase Fed purchases which will push stocks higher

David Tepper pictured below. He is the highest paid hedge fund manager in the world who does very well when the market rises and gets crushed when the markets fall. His fund lost 28% during 2008, and he lost 25% in just a few months during 1998 betting on a bullish turn in Russian bonds (which defaulted).

This of course is the same exact reason we heard stocks would rise forever back in March 2000 and November 2007. There was a "Fed put" under the market that would always keep stocks propped up and push them higher, like a lever, whenever they felt like kindly making people richer.

The market's view of the Fed is now well beyond the irrationality seen in at the previous peaks over the last 13 years. The Fed is truly now considered god-like, where most investment decisions are focused only on how much stimulus Bernanke will provide to save us.

Some go beyond the Fed irrationality and add that the market is now extremely "cheap." This is done using a price to earnings ratio (P/E). The market projects ahead what they believe earnings will be 12 months from now and they apply this outlook to the price of stocks today. This is of course insane for anyone with common sense, but it is exactly what you hear about on 24 hour mainstream news networks from paid financial professionals.

Market participants tell us that the market is currently trading at a 14.3x P/E ratio, which is cheap historically. In order to get to this cheap P/E ratio earnings just have to grow at 28% over the next 5 quarters. Should be no problems, right?

The chart below show the rate of earnings growth in red. The earnings growth rate, currently at 2.48%, has been falling steadily and is approaching negative territory at its current pace. A negative real growth rate in earnings could change the outlook for stocks rapidly, which have already priced in 28% fantasy growth.

This is why financial professionals are always so shocked at market highs. If you put an artificial number into your model then you can make any price look cheap.

The better metric to use is real earnings, or what has actually been taking place on the balance sheets of companies over the previous 12 months. Using this metric, we can see in the chart below that the trailing 12 month P/E ratio topped out at 17.7x earnings at the market peak in 2007. Where are we today? We have blasted past that point and now sit at trailing 12 month P/E ratio of 19x earnings.

We were told that the market was cheap in late 2007 because financial professionals then were using forecasted earnings for the future. In October 2007, forward projected earnings were at $110 a share - creating the illusion that companies were trading at only 16x earnings. Earnings ended up coming in slightly below that forecast the following $55 a share or 50% below the forecast.

Let's now move back to where we began. As asset classes have topped and begun the process of rolling over around the world, why has the United States stock market launched higher into the stratosphere all by itself?

The answer is leverage driven by sentiment. Investors are so confident today that the Fed is in complete control today that they have borrowed more money than any time in history to bet that prices will go higher from here. It is like being so confident playing roulette in Vegas that the next ball will land on black that you borrow $100,000 from family and friends to bet on it. The following chart shows this new record setting margin at our current record setting stock prices:

Margin is a beautiful thing for market participants. If you have 90% leveraged on a trade (you have $10 of your own money with $90 borrowed) that a stock will move higher, a 1% move higher in that stock nets you a 10% gain on your money.

The problem we have seen is what happens when everyone moves in with all their cash and then borrows as much money as possible to bet even more on the stock market casino moving higher. If the trade reverses due to a small loss of faith, such as what we experienced with the utterance of the word "taper" in June, then you will experience a waterfall decline in prices. We have seen this process before during the rolling tops of the past 13 years:

Let's take a brief trip back to the 1920's. The PE ratio for the stock market was 17.5x earnings in 1929, just before the greatest crash in market history. Today the stock market is fundamentally more expensive than that monumental high.

How high can markets go before they face reality? Much higher. However, markets are already more dangerous at this exact moment in time than at any point in the history of the American stock exchange. That includes 1929 and 2007. High frequency trading now allows the possibility that the next collapse could mirror something closer to 1987 where the markets enter a panic free fall. The coming liquidation could be over in hours or days vs. the month long declines we have seen in the past.

Up Next: 2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake


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