Identifying Short and Long Term Trends for 2011 - Part I
(December 31, 2010)
Dear Subscribers and Readers,
My friend and business partner, Rex Hui, and I would like to express our gratitude for your ongoing support in MarketThoughts.com. 2010 has been a relatively calm year for the financial markets, despite the ongoing deleveraging in the developed economies (not to mention the “simmering” in Western Europe!) and the inflationary threats in China and other emerging economies. We wish all our subscribers the best in 2011 and beyond. We would also like to thank our regular guest commentator, Mr. Rick Konrad of Value Discipline for his absolutely invaluable semi-monthly commentaries, as well as to posters rffrydr, nodoodahs, diesel, and smile for their immense contributions and active participation our discussion forum (please drop by when you have time). We also would like to welcome back the poster dash, who has been on hiatus from the markets over the last several years. Please keep your creative ideas and juices flowing! Similar to last year and the year before (please refer to our December 30, 2009 commentary “Identifying Short and Long Term Trends for 2010 – Part I” and our January 10, 2010 commentary “Identifying Short and Long Term Trends for 2010 – Part II”), this will be the first in our two-part commentaries containing our investment and economic outlooks for 2011 and beyond. The second part of our two-part commentaries will be published this weekend. In this commentary, I would like to summarize the performance of the U.S. stock market in 2010—and then move on to our outlook for the U.S. stock market/economy in 2011 and beyond. Without further ado, let us now dive right in.
As of the close on December 29, 2010, the S&P 500 is up 15.09% YTD on a total return basis. This is a far cry from the 26.46% return in 2009—but it's about what we had expected the market would return this time last year. Quoting our December 30, 2009 commentary: “My sense is that stock market returns (as measured by the Dow Industrials and the S&P 500 will be relatively tepid in 2010 (at least compared to 2009). While I believe 2010 will be an up year, I don't believe the Dow Industrials will close 2010 at 12,000 or higher.” Note, however, that the S&P 500 is still approximately 9% away from reaching its year-end 2007 level, as 2008 (decline of 37.00%) was its worst performing calendar year since 1931.
All ten economic sectors within the S&P 500 are up on a YTD basis. Out of these ten sectors, the S&P 500 consumer discretionary index performed the best YTD (+26.0%; after ranking as the third best performing sector in 2009). Who says the US consumer is dead? This is followed by Industrials (+23.8%), Materials (+19.8%) and Energy (+17.9%). The worst performing sectors are Health Care (+0.8%), Utilities (+0.9%), Information Technology (+9.4%), and Financials (+10.6%). On a more granular level, the five best performing stocks within the S&P 500 YTD are Netflix (+226.4%), F5 Networks (+150.0%), Cummins (+140.2%), AIG (+91.9%), and Zions Bancorp (+89.2%). Meanwhile, the worst performing stocks within the S&P 500 are Weyerhaeuser (-56.1%), Dean Foods (-52.0%), H&R Block (-47.9%), Apollo (-34.5%), and Diamond Offshore Drilling (-33.0%).
In last year's outlook, I stated that the market was overbought in the short-term, but that the cyclical bull market that began in March 2009 remained intact. I also cited the ongoing problems in the European banking system, as well as rapidly rising prices in Chinese real estate (the latter did not turn out to be a problem, although I believe it would in 2011). The market suffered a quick correction from mid-January to early February—then quickly resumed its climb. Starting in late March, we became less bullish as the market and investor sentiment got even more overbought. On March 29, 2010, we shifted from a 100% long position to a 50% long position in our DJIA Timing System at a DJIA print of 10,888; and on April 27, 2010, to a completely neutral position at a DJIA print of 11,044. On May 21, 2010, we became incrementally bullish—shifting to a 50% long position at a DJIA print of 10,145. Thereafter, we remained 50% long until December 15, 2010, when we shifted to a completely neutral position again at a DJIA print of 11,487. Over the last several weeks, both the market and investor sentiment has become severely overbought—and we believe that the market will likely experience a 5% to 10% correction starting sometime in January (once end-of-year “window dressing” is over).
In a bull market, the toughest endeavor is adopting a buy-and-hold strategy—the strategy that is usually the most profitable (and stress free!). Sure, we have made several tactical moves since March 2009, but that is part of our mission. As such, it is most important for us, as investors, to learn and understand our own psychological makeup and how it affects our investment decisions—both during tough and “normal” bull market times. This topic was alluded to in last year's outlook. Again, successful investing requires discipline, a long-term plan, and the need to understand yourself, and to “block out” everyday noise (turn off CNBC). Last year, we asked our subscribers to read or re-read Peter Lynch's “One Up on Wall Street.” We stated that not only does the book give you some common sense ways to beat the S&P 500 through individual stock picking, it also tells you if you should invest in individual stocks in the first place. This year, I recommend a book that would give you a better understanding of your own psyche and how to block out the investment noise. In his book, “The Intuitive Investor: A radical guide for manifesting wealth,” former fund manager Jason Apollo Voss reveals why it is so hard to beat the averages through quantitative methods and the common information-gathering methods—and why in order to beat the Averages, one would need to open his/her creative side—that is, the right side of one's brain. Through exercises such as meditation to “clear out” and filter the most important/relevant information, as well as ways to assess the “collective unconscious” (a term coined by Carl Jung), Mr. Voss asserts that investors could easily beat the averages without being overwhelmed by information. It is highly original and incorporates both science (including our understanding of quantum mechanics and string theory) and spirituality.
Many subscribers know that I don't read books that discuss the recent financial past unless they are timeless. For example, books written about the financial crisis are generally a waste of time--we should understand these issues as they are happening; not after the fact. In light of my reading philosophy, I recommend subscribers pick up Capitalism 4.0—a book which does a splendid job of summarizing the development of capitalism since Napoleonic times and posits how global capitalism will evolve out of the ashes of the 2007 to 2009 financial crisis. It is highly intelligent (and controversial) work. For those who like biographies, I highly recommend Ron Chernow's “Washington: A Life.” Ron Chernow is one of my favorite non-fiction authors and has also written a splendid work on Alexander Hamilton (a must-read for us financial types), the Morgan Family, and John D. Rockefeller.
Our 2011 Outlook for the U.S. Stock Market
The ancient Chinese believed that by establishing a spiritual connection with the Heavens using the Yijing (“Classic of Changes”) as a medium, we could fathom the cosmos and establish order in our lives and the world. We do not profess to have this ability (if we did, we would not be telling you)—at this time, the best we could say is that both our short-term and long-term outlook for the U.S. stock market has not changed. The cyclical bull market that began in early March 2009 remains intact. In fact, Lowry's Buying Pressure Index has just touched a new cyclical bull market high, while its Selling Pressure Index a new cyclical bull market low. More glaringly, its Buying Pressure Index crossed over its Selling Pressure Index last week—thus reconfirming the cyclical bull market. Combined with record low interest rates, decent liquidity, and decent valuations, the 12-month outlook for the U.S. stock market is definitely bullish. In the short-run, however, I expect an imminent correction, given the overbought nature of the stock market and the most bullish investor sentiment (as exemplified by various investor surveys, the equity put/call ratio, the VIX, etc.) over the last few years. Moreover, both upside breadth and volume have lagged over the last several weeks. We expect this correction to be short, however (possibly coinciding with the resumption of the European sovereign debt crisis, or a scare over Chinese economic growth).
Interestingly, investors have continued to pull money out of mutual funds that invest in U.S. equities. According to ICI, U.S. investors posted a net inflow of $390 million into equity funds in November, with $6.86 billion going into foreign equity funds; while pulling $6.46 billion from U.S. equity funds! This is on top of an outflow of $7.15 billion out of U.S. equity funds in October. YTD to month-end November, all equity funds experienced an outflow of $29.6 billion; with U.S. equity funds experiencing a net outflow of over $74 billion! Clearly, many retail (those that invest through their 401(k)s) and institutional investors (such as defined benefit pension plans) remain hesitant on equities, especially U.S. equities. In other words, investors still do not want to be owners of some of the greatest global businesses created since the dawn of the Industrial Revolution, despite record low interest rates, a stabilization of the global financial system, an improving U.S. economy, and decent valuations.
Over the next 12 months, I expect investors to become more bullish on U.S. equities. On a technical basis (as we have illustrated many times before), there are no signs at all that the cyclical bull market that began on March 9, 2009 has topped out. All the classic signs of a top – such as rampant retail investor bullishness, a weakening in upside breadth (as exemplified by a weakening of the NYSE Common Stock Only A/D Line), extremely high valuations/corporate leverage, and a tightening Fed (the Fed is even talking about implementing QE3!) – are simply not there. Moreover, Lowry's proprietary Selling Pressure index just sank to a new rally low while Lowry's Buying Pressure Index rose to a new rally high – thus confirming the ongoing uptrend in the U.S. stock market.
On a valuation basis—despite the 15% return in 2010—the U.S. stock market is still fairly valued. For example, the price-to-book ratio of the S&P 500 stands at 2.3 (see below chart)—slightly lower than the 34-year average of 2.4. In addition, subscribers should note that the book value of many companies in the S&P 500, such as Microsoft and Amgen, may be understated as R&D spending is treated as an expense, and not capitalized on the balance sheet. This may understate the S&P 500's book value today, relative to that of the past, as today's companies are more R&D focused than those of the past (e.g. the book value of the S&P 500 Information Technology Sector is 3.8).
Furthermore, the cyclically-adjusted P/E ratio of the S&P 500 (using today's price divided by the 10-year trailing EPS of the S&P 500), is currently just over 15, which happens to be lower than the 81-year average of 16.7 (per Goldman Sachs). Also, the forward P/E currently stands at just 13.5:
Given the strong support being provided by the world's major central banks, decent valuations, and strong demand/momentum in U.S. equities, I believe 2011 will be an up year for U.S. stocks. Given the short-term overbought conditions of the stock market, the ongoing troubles within the European banking system, and the overheating Chinese real estate market, I believe the market will undergo a 5% to 10% correction starting next month. Last year was a “transition year” for the U.S. and global stock market. Issues within the European banking system were left to simmer, while the innovation/R&D front still lacked visibility. 2011 will be different. Market participants are now pushing European policymakers to act—and I believe some kind of solution (closure) will be crafted within the next couple of months (or else). More important, there will be “inklings” on the innovation—innovation which would finally lead to long-awaited “Schumpeterian growth.” For example, both the Chevy Volt and the Nissan Leaf would finally be on the road—these two vehicles will likely spur more innovations in the area of battery technology. The long-awaited “Blue Waters” supercomputer—with a peak performance of 10 petaflops—will come online towards the end of the year. Soon afterwards, the 10-petaflop “Pleiades” and the 20-petaflop “Sequoia” will also come online. Combined, these three supercomputers (all built and to come online in the U.S.) will have a peak performance equivalent to all 500 supercomputers currently on the “Top 500” list. There would also be more significant news items on the possible commercialization of the quantum computer.
Closer to fruition, I believe that 2011 would also be a year of “augmented reality” glasses, although they would be prohibitively expensive (>$2,000) for the average U.S. consumer (and perhaps too nerdy, at least initially). The cost of 3D printing will also continue to decrease—and the technology will improve sufficiently to allowing U.S. companies to ponder shifting some of their manufacturing back into domestic soil (a 3D printer just “printed” the world's first flute). My point is that there is now more visibility on the innovation front—but whether any of this will capture the imagination (i.e. the animal spirits) of U.S. investors is hard to know. I will tackle this issue again later this year. I believe 2011 will be an up year—and it could be an above-average returning year if U.S. companies surprise on the innovation front.
Sometime in the next 5 to 10 years, the next era of Schumpeterian growth will finally arrive. The development and commercialization of such technologies (perhaps accelerated by the commercialization of the quantum computer, or by cheaper energy sources) will have a similar impact on U.S. economic growth as that of the development and/or spread of the U.S. canal system, the railroads, the telegraph, electricity, refrigeration, the automobile, radio, penicillin, the transistor, television, the personal computer, and the internet. Possible candidates include advances in fields such as biotechnology (customized therapies based on genetic sequencing, stem cell therapies for treatments of Alzheimer's, etc., various anti-aging therapies, etc.), nanomaterials (stronger and lighter materials such as carbon nanotubes, or better conductors, etc.), alternative energy (more efficient solar panels that could put solar power at “grid parity,” commercialization of cellulosic ethanol and the discovery of second-generation biofuels that could put nuclear power to shame), and possibly the commercialization of space (lighter nanomaterials could easily reduce the cost of a space trip by a factor of 10). This next wave of Schumpeterian growth will drive the next great bull market in U.S. stocks, venture capital, and private equity investments.
Our 2011 Outlook for the U.S. Economy
Last year, we commented, “In the short-run, U.S. economic growth will still be dictated by the deleveraging of U.S. consumers' balance sheets, as well as pressure on the Obama administration to rein in the federal budget deficit. While U.S. real GDP growth in 4Q 2009 should be at 4% or over (due to the fiscal stimulus as well as inventory restocking), my guess is that U.S. real GDP growth in 2010 will be below-trend at 2% to 3%. Most likely, U.S. real GDP growth in 2010 will peak in the first half of the year, and decline gradually in the second half as the impact of the $787 billion fiscal stimulus plan starts to wear off.”
4Q 2009 real GDP growth turned out to be 5.0%. Quarterly GDP growth peaked at an annualized 3.7% in 1Q 2010, declining to just 1.7% in 2Q 2010. 3Q 2010 GDP growth is estimated to be 2.6%. According to economists, 4Q GDP growth is expected to come in at 3.0%--and perhaps slightly more—given the upside surprise in holiday retail sales. For 2010, real GDP growth is estimated to be 2.8%--which is within our estimate of 2% to 3% in last year's forecast.
For 2011, I expect GDP growth to be significantly higher, as consumer deleveraging will definitely slow down and given the extension of the Bush tax cuts. I expect the U.S. unemployment rate to slowly decline in the first half of the year—then accelerate in the second half as Europe and Japan resume its normal growth trajectory. The graduation of the 2011 MBA, JD, and undergraduate class in the summer will have less of an impact than last year. Companies are now starting to hire more aggressively—which is not a surprise given that U.S. companies have $1.9 trillion sitting on its collective balance sheet, while employee compensation as a percentage of U.S. GDP has just declined to a new 55-year low (as shown on the following chart)!
As shown on the above chart, U.S. employees' compensation as a percentage of U.S. GDP recently bottomed at 54.4%--the lowest level since 1Q 1955. In addition, total employees' compensation is still lower than its peak two years ago. This is unprecedented (based on post WWII data). With record low interest rates, a slowing in U.S. household deleveraging, an anticipated increase in corporate capital spending and hiring, and ongoing growth in emerging markets, I expect U.S. hiring (and salary increases) to pick up dramatically in 2011. Another bright side to the recent recession is that many bright students in the natural sciences and engineering fields have chosen to get their PhDs and stay in their fields, instead of heading to Wall Street or law practice. More monetary and talent research in the basic sciences and technology sectors will drive Schumpeterian growth yet further.
Meanwhile, we will continue to watch the European sovereign debt crisis unfold in the New Year, as well as the potential overheating in the Chinese economy. The next shoe to drop could be a rise in Japanese bond yields, as the Japanese fiscal situation is now getting very much out of hand (which is not good given the horrible demographics in Japan). Any pick-up in Japanese bond yields could be a disaster for Japanese banks and Japanese savers—and could hamper the Japanese government to finance its ongoing deficits. We will pay closer attention to both China and Japan in 2011.
All the best to our subscribers and we wish you a great and happy New Year's and a prosperous 2011!
Henry To, CFA, CAIA