By Kelpie Capital
This post is an amalgam of various emails I penned over the course of July, August and September trying to provide hard evidence to support my belief that we are slipping into another recession in Q4 or Q1 2012 which unfortunately, will most likely be global in nature.
This is clearly not currently the consensus on The Street, although we have seen over the last quarter that global growth forecasts have been lowered and people are at least considering the possibility that it might happen. I’d like to contrast this with the beginning of 2011 when outlooks were MUCH rosier and people GENUINELY, in their heart of hearts, thought that we’d see rate interest rises in the developed world up to maybe 2%.
Many Sell-Side analysts are currently telling us that a recession is now already fully discounted in stock prices – I respectfully disagree. These are the same sell-side analysts who didn’t see even a remote recession risk just 6 months ago and the same guys who didn’t see a recession coming down the tracks in 2007 either.
Most value investors don’t pay much attention to the macro situation but I think they are missing a trick. Given that the average stock market decline during a recession is 40% it seems to me that an attempt to be “macro aware” is worth the effort!
The Purpose of this Post is to encourage caution! Although much of what I post on this blog will be long equity ideas I do think that I should emphasise that I am not bullish on the broad indexes, infact I err bearishly! I usually hedge my longs with at least some degree of shorts on various indexes of my choice. These are not valuation levels at which I want to be naked long and the political/economic/monetary picture is so cloudy that I fear we must practice defensive investing. More Cash, Lower Net Exposure.
I don’t particularly like this from M&G and David Rosenberg. I don’t like that it relies upon only ONE variable, but it works.
As you can see the blue line tends to lead the orange line, effectively the business “outlook” leads the actual output of the economy which makes intuitive sense. Businesses become more pessimistic and then reign in spending which has knock on effects throughout the supply chain. Only the instance in 2001 acts as an exception – when the economy didn’t quite slump along with business confidence.
This more complete analysis is lifted from the supremely insightful and diligent John Hussman – he has compiled what he calls a “Recession Warning Composite”….
“The components of our recession warning composite might be called “weak learners” in that none of them, individually, has a particularly notable record in anticipating recessions. The full syndrome of conditions, however, captures a critical “signature” of recessions. That signature of “early warning” conditions is based on financial market indicators including credit spreads, equity prices and yield curve behavior, coupled with slowing in measures of employment and business activity. Every historical instance of this full syndrome has been associated with an ongoing or immediately impending recession.”
The components are:
1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.
2: Falling stock prices: S&P 500 below its level of 6 months earlier.
3: Weak ISM Purchasing Managers Index: PMI below 50, or
3: (alternate): Moderating ISM and employment growth: PMI below 54, coupled with slowing employment growth: either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron’s piece many years ago), or an unemployment rate up 0.4% or more from its 12-month low.
4: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields if condition 3 is in effect, or any difference of less than 3.1%
Components 1, 2 and 4 are all obviously flashing RED for danger and we posted an August PMI of 50.6 for the US Economy! In addition, we have an unemployment rate that is starting to creep up again from already elevated levels. So as far as I’m concerned Criteria 3 has been met too. What that means is that EITHER this composite will be proven wrong and its 100% track record is ruined or we will enter another recession. Given the tepid nature of the data, the mess in Europe and the negative growth surprises in Asia, I fail to see where the US economy pulls the proverbial rabbit from.
Look at the video below with Lakshman Achuthan of the Economic Cycle Research Institute. As he points out he has no record of being wrong on this, his recession call track record is perfect. This video is a must watch.
“A broad range – this is not based on any one indicator – this is based on dozens of indicators for the United States – there is a contagion among those forward looking indicators that we only see at the onset of a business cycle recession.
A recession is a process, and I think a lot of people don’t understand that; they’re looking for two negative quarters of GDP. But it is a process where sales disappoint, so production falls, employment falls, income falls, and then sales fall. That vicious circle has started.”
Emerging Markets Are NOT going to Save Us
Remember that below 50 on the PMI means an economy that is contracting.
Here we are three years on from Lehman – 300 year low interest rates, mega stimulus, currency printing and competitive devaluation: Outcome – no more jobs, tepid growth, no housing recovery and bigger problems with bigger banks.
Globally economies are simultaneously swan-diving off a cliff and our collective faith in the fabled “policy response” is dwindling.
As I have been saying for MONTHS the big factor not being looked at is that Earnings Expectations are way, way too high and they are based upon the perpetuation of what are peak profit margins – there is a good chance that Q4 and Q1 2012 earnings seasons will be horrific.
If Analysts pull down earnings numbers, then all of a sudden the “market is cheap on forward earnings” crowd don’t have a leg to stand on. The first signs of this have been seen in the last few weeks – Eurozone Earnings Estimates off more than 10% but the US has barely budged. To exacerbate this further, Goldman Sachs made a loss and Apple missed on it’s earnings estimates! Apple has beaten estimates THIRTY consecutive quarters – that goes back more than 7 years!!! These are 2 of the market generals that have led the recovery.
As Jeremy Grantham said – “This is no Market for Young Men”, since 1982 the market has favoured participants who underestimate the true nature of every crisis (The Optimists!). In such an environment the “buy the dips” mentality has been conditioned – there is a strong possibility that this gets beaten out of them here.
Bonus Points for the few who read this far…..Mohammed El Erian sounds disctinctly bearish too…..
If there is a recession Equity Markets will decline – do not for a second think that a full blown recession is priced in, especially in the US at 19x CAPE for the S&P 500! Furthermore, if we see profit margins mean revert then the earnings will start to fall too meaning that the numerator and denominator are declining in tandem causing precipitous falls in many highly rated equities. The proverbial “Double Whammy”!
Looking at the chart below (credit John Hussman) we can see a standardized composite of Economic Activity metrics. The current reading on the composite has been lower than its present reading ONLY 10 times in the last 43 years – 7 of them during a recession, 1 immediately prior to the 2008 recession and 2 false signals. That’s an 80% chance that the economy is about to double dip.
Below is a Probability Table put together by John Hussman using a broad basket of economic indicators – it’s a bit messy but it’s message is clear! The probability of the US being either in a recession or on the cusp of one is north of 90%. If you look at the black lines contrasted against the blue – you can see again there are ZERO false positives when the model predicts a recession with such a high probability. Maybe this time is somehow different. I just think it’s a poor idea to ignore the data here.
As of the latest GDP report, corporate profits are now at the highest ratio to GDP in history. The chart below illustrates the danger in extrapolating current high profit margins into the future. The blue line presents the ratio of profits/GDP (left scale). The red line presents the annual growth of corporate profits over the following 5-year period, and the right scale is inverted. Higher profit margins are predictably related to weak subsequent earnings growth over time.
This dynamic is why profit margins have a clear negative correlation with subsequent 5-10 year returns. Profit margins are currently very high, they have a very reliable tendency to mean revert, high margins are always associated with poor future realised returns – why do investors continue to pretend this is not the case!?
To put it as simply as possible – IF the red line continues to track the blue line, as it has ALWAYS done, we are in for very poor/negative profit growth for equities!
To paraphrase Grantham, if high profit margins can persist indefinitely then capitalism is broken and we have bigger issues at hand. High profit margins should attract competitors to an industry which will over time erode margins down to more normal/average levels.
Unfortunately, we are just about “due” one. The last recession began in 2007, that’s 4 whole years ago. Most agree that we are in for an extended period of slow growth with high and sticky unemployment. What goes along with this “New Normal” deleveraging environment resulting from a credit crisis is volatile markets with a secular grinding lower of the market P/E multiple along with more frequent recessions a la Japan. Central Banks have no Policy Tools left to save us – they have fired the QE Bazooka and rates are already at the zero bound.