The Only Thing Certain is Uncertainty

The more I think about the future the greater my uncertainty becomes. Two years ago I was expecting a global melt up in stocks as the global economy recovered, but as the recovery became more and more wishful thinking, I gave up too soon last year.  The 2017 stock rally has convinced many that now is the time, but we now have the bulk of wealth controlled by baby boomers that are unlikely to abandon the safety of bonds, while the impetuous youthful generation is now pursuing the astronomical promise of wealth offered by crypto currencies.

The greatest change in global financial markets has been the acceptance of quantitative easing, or central bank purchase of bonds to artificially suppress interest rates.  Japan was the first major developed country to implement QE in the 1990’s, and although their stock market never returned to 1989 highs and their economic growth never returned either.  There has been no previous attempt to reverse QE, and both the US and Europe plan on doing so over the next few years.  The effects that the reversal of QE has will be the greatest source of uncertainty, barring war, for the next ten years or more.

My personal feeling is that QE has not only suppressed interest rates, but has also suppressed the risk appetite of corporations for investing in the economy, replacing the building of factories and the hiring of more workers with stock buybacks.   It is likely then that the reversal of QE will decrease the demand for financialization and increase first growth and then inflation.

How this plays out in financial markets is the real question.  If growth increases faster than interest rates, then a melt up in stock markets becomes more likely.  However, if interest rates increase faster then a moderate bear market is more likely.  Demographics seem to favor a slower increase in rates, since retirees are unlikely to throw their life savings into stocks given the volatility of the past twenty years.

My personal bias is a moderate bear market over the next two to three years, similar to the 1970-72 bear market with a longer term similarity to the 1970s.  I seriously doubt that more than a 50% correction is seen from the highs that could still go 10% higher, and the larger correction may be 5 to 7 years away.  The housing crisis and bust was relatively easy to spot and was mainly due to policy errors with a president that fired his economic advisor after warning of a possible housing crisis, a Fed head that insisted the risk was minimal, and the exit of Buffet from the market in 2006.  It is doubtful that central banks will not be more watchful for the next few years.


What Happens When Growth Returns?

Since my last update from March 2015, I have since started a separate blog for weekly updates using a stock market-oriented timing model based on market sentiment measures.  This blog is being reserved for long-term forecasts of a year or more.

I. The Answer

Previously, I tried to show that high stock valuations are reasonable in a low growth economy with very low interest rates.  Now with the election of a pro-growth President with similar policies to George Bush II, it might be reasonable to target an economy similar to 2000 when the GB2 era began.  In 2000, US GDP growth was 4%, inflation was 3% and interest rates (TNX) were over 6.0%.  Thus growth and inflation were about twice what they have been and interest rates were more than three times what they have been.

The gold bugs and stock market bulls want to focus only on the growth and inflation possibilities which would argue for a doubling of stock prices to DJIA 30,000+ and gold at $3,000 an ounce.  I admit, that I also entertained this idea in my previous post, but that was based on a global growth recovery.  Without global growth, I view the global economy as a six-cylinder car running on only three to four cylinders where the US is two cylinders, Europe is two, China one and the ROW one.   What I expected was a stronger US dollar that would have slowed the US temporarily, but helped Europe and the ROW.  But the US has delayed raising rates for too long and Europe is probably now beyond recovery.

So to return to the growth scenario, ignoring higher rates that were present in 2000 is like having your cake and eating it too.  In reality, stock prices topped in 2000 with the DJIA just below 12,000 and gold was only $300 an ounce.  To use the approach of the dividend growth model from my 2015 post as a two factor model, growth acts as a multiplier, but interest rates act as a divisor.  Therefore, from the current price level for the DJIA at 19,000, if you double to 38,000 for growth then divide by three for higher interest rates you get 12,667.  Likewise for gold at $1,200, times two is 2,400, and divide by three is $800.  Obviously, this a very simplistic valuation approach and not a prediction, but I just wanted to point out that a return to growth may not be as bullish as many want you to believe.

II. The Forecast

The stock markets over the last two weeks certainly seem to be following the path I outlined in March of 2015, the “blow off” stage, but since developing a more pragmatic approach to market timing, I have my doubts about its durability.  In my weekly blog I try to measure extremes of market sentiment for stocks, bonds and gold using a variety of measures including the comparison of money flows between short and long ETFs.  For instance on November 13, I showed this chart of the Short/Long ETFS SDS/SSO for the SPX updated for last week.


Here the idea is that higher levels of shorts relative to longs are bullish, while higher levels of longs is bearish.  Since the middle of 2014, the longs were mostly the majority which held the market in check.  This is a long term moving average and does not preclude a short term blow off, but certainly argues against the beginning of a new bull market.

My conclusion is that stocks are likely to begin a long term consolidation period ranging between a high of DJIA 20,000 and a low of 10,000 possibly similar to the 1970’s in duration.  Opposite to the 1970’s, the economy is likely to alternate between periods of growth and deflation (compared to the 1970’s inflation), and counter intuitively asset prices are likely to rise during deflation due to lower interest rates and fall during periods of growth and higher interest rates.

Recent deflationary events such as the BREXIT and the recent “No” vote on the Italian referendum have supported this idea as markets reacted positively due to expected central bank support.  But in any case for the US markets, I expect a top early in the year with a decline into the fall of about 15% to 20%, mostly due to a rise in interest rates with the TNX approaching 3.5% to 4.0% by that time.

“Are high stock prices reasonable in a low growth economy?”  

To answer this question, I decided to setup a simple valuation metric starting in a state when prices were seen as fairly valued using the dividend discount model (DDM) to find the fair value (FV), where D1 [D0*(1+g)] is the expected dividend, k is the discount rate (yield on 10-yr TBond), and g is the constant growth rate.

[In geek speak, observations are single-period, steady states where variables are in equilibrium, especially the risk premium (k-g). I want to point out that D1 makes no sense and reasonableness is probably due to offsetting errors in risk premium (k-g).]

To get started, I used the 1980 period after Volcker raised the Fed funds rate to 20%, TBonds were at 16%, and grow was 8% approx. I then plugged in a D1 that would give me a FV of 1000 on the DJIA. Not knowing what to expect, I created several states as both interest rates and growth fell by 50%. As shown below, each lower growth state produced a value multiplier of 100%.


Next, I asked myself “Is this reasonable?”

The second row roughly equals the 1980s value metric where DJIA fair value would be 2160. Steady state variables may vary over time, especially in overvaluation that sees lower risk premiums and higher g, but usually results in a “snap-back” as variables return to the steady state. For instance in the first half of 1987 the DJIA reached 2750, then snapped back to 1800 in the Oct crash.

The third row represents the 1990s, where risk premiums became very small as growth soared. However, starting in 2000 with the dot-com crash the DJIA went from 12000 to 7000 never reaching fair value although the SPX went down 50% and the Techs 80%.

The fourth row is roughly where we are today with the 10-yr TBond at 2% and steady state growth at 1%. FV for the DJIA is 9165 which compared to 18000 means the stock market is 100% overvalued. For those of you who read John Hussman, you know that this is exactly what he has been saying for the past two months and his models are much more complicated.

So, yes the results are reasonable.

The sixth row is the Japanese scenario where long term growth continues to spiral downward. I see this as unlikely at present.

My most likely scenario. The recent rise in the dollar and collapse of the Euro has certainly clarified what I see as “no way out”. It is likely that the US economy will enter row five the first half of next year as the economy slows down and 10-yr rates approach 1%. However, by the second half of next year the collapse in the Euro should turnaround the EU economy, possibly sharply. As to US stocks, low growth will push valuations up to DJIA 18514. I expect the price levels to increase by the change in valuation or to about 27000 by the end of next year. A small “snap back” may be seen in the traditional May-Oct selloff period in 2015.

The following two years should see a steady improvement in economic growth worldwide and a decline in the US dollar as the global economy moves into row three, the 2% inflation range where 10-year rates return to 4% and growth is 2%.

Here is where we find the monster in the closet. As interest rates rise, bond portfolios represented by the 20-year TLT will lose 40%. Retail investors who have fled the stock market into bonds because of the weak economy will find that stocks have gotten away from them and as bond losses continue to mount are likely to panic out of bonds and back into stocks, driving interest rates even higher. Stock prices will continue to rise even as fair value falls due to higher interest rates. The DJIA rises to 36000 or beyond as fair value approaches 4500. A panic out of bonds could compress this to one year.

Now we get a snap-back or dislocation similar to 1929 that continues for about three years as the stock market gets back to fair value.

In conclusion, financial repression may force investors to pay higher and higher prices for low returns, but there is no way out.