Conversations With a Bear
"Stocks Likely To Crater From Here," read the subject line of an email that landed in my inbox last week.
"Sequestration cuts, weakening GDP growth, higher taxes and high gasoline prices are all but a few reasons why author and economic researcher Chris Martenson PH.D foresees the stock market likely to plummet within the coming months," it warned.
I usually ignore such hyper-specific emails, but I gave this one a look for one reason: I feel better about the economy now than I have in a while, and in an attempt to avoid confirmation bias, it's always best to bounce your thoughts off someone who disagrees with you.
So Chris and I exchanged a back-and-forth chat about the economy and investments. Here's the transcript, condensed for clarity.
Morgan Housel: You cite an increase in taxes and gas prices as a reason you expect stocks to plummet. But the last time we raised taxes in the early 1990s, stocks surged. Same with tax hikes in the 1950s. And gas prices are up 40% over the last three years, yet stocks are up by more than a third during that time. I'm not saying it's causation; just that the relationship is much more complicated than we often think. I just don't see the evidence that higher taxes or higher gas prices automatically lead to poor stock returns. (And for what it's worth, gas prices have been falling for a month now).
Chris Martenson: My thinking here is that stocks do respond poorly to are falling earnings and recessions are a powerful driver for falling earnings. Rising energy prices are well correlated with recessions and so I see high gasoline prices as a headwind to economic growth. The US economy is barely above stall speed when measured in terms of real GDP, and is a tick below the 3.7% nominal growth threshold that has been breached in every recession stretching back to 1980 (and at no other times, I should note). It is in the context of a weak economy that I wish to observe that the recent tax hikes and spending cuts of the US government provide yet more recessionary weight to the current environment.
Morgan: So the call, then, is for a looming outright recession? I agree that recession would be bad for stocks, of course. And while you can never rule out the possibility of a recession -- we're very bad at predicting them -- the negatives of higher energy prices and tax hikes can be countered by a number of things going right in the economy. Housing starts are rising at an annual rate of more than 25%, and will likely keep rising given low inventory and demographic trends. Household debt payments as a share of income are at a three-decade low, and there's evidence that consumer deleveraging is now complete. Energy production is booming. The near-stagnant GDP growth in the fourth quarter was almost entirely due to a big pullback in defense spending, which itself was the echo of a big rise in defense spending in the third quarter. And while gas prices have risen since last fall, prices are lower today than they were a year ago, and considerably lower than they were in mid-2011 -- to say nothing of real prices after nominal wage growth.
I would never rule out a recession, but the odds of one occurring in the coming year seem rather low to me, perhaps one in five. What odds do you place on a recession occurring?
Chris: I consider one to be far more likely than not, well over 50% in the US ... and the combined impacts of the sequester and Obamacare which I peg at between -1.5% and -2.5% for 2013. The sequester is easy to peg, that's going to be 0.6% full year, but at an annualized rate of -1% between here and Oct 1, 2013. ...
You cite many positive aspects, including booming energy production, and I'm pretty much in agreement with all of them with two caveats. First oil production is up, but this isn't your grandpa's oil, it is expensive oil. With the all-in cost of production for new oil in range of $70-$90 per barrel, we'll see a nice reduction in our import requirements, but not in the hits to disposable income. By my records at $3.50 gal avg., gasoline is twice as expensive as it was a decade ago, and that is an important factor to consider.
Second, household debt payments are as low as they are principally because of low interest rates, and less so because less debt is being carried, an essential part of the definition of (and psychological benefit of) deleveraging. To put numbers to this, the Debt Service Ratio (DSR) has fallen from a bit over 14% at the end of 2007 to 10.4% today for a decline of ~35%. However, household debt has declined from $13.763 trillion (Q108) to $12.844 trillion or by just a bit over 7%. ... I feel it is essential context.
All told, I am increasingly convinced that the risks of recession are higher than not and that prudence will serve investors better than greed.
Morgan: So let's say we're heading for a recession this year. What's should an investor do with his or her money?
Chris: I am especially leery of high yield bonds which have just hit all time, as in never-before-seen, highs. The class of companies that comprise the high yield bond universe do quite poorly in times of stress, for obvious reasons.
My general advice goes like this:
- Get out of high interest debt that is higher than your likely investment returns. Paying down credit card debt, auto loans and the like is one of the better investment moves you can make. Plus it feels good.
- With your next tranche of funds, invest in your house, if you own one. Investments in things like insulation ,energy efficiency, solar hot water and/or geothermal typically have double digit returns, sometimes even triple digit, where your only risk is that energy prices fall dramatically. It's time to broaden the definition of 'investment' to include prudent investments to day that reduce your future cash flows tomorrow.
- Put a minimum of 10% of your portfolio in gold. I have been giving this advice since 2003 and continue to give it because gold is the only monetary instrument I know of that is not simultaneously someday else's liability. Given all the QE and other overt forms of debasement ongoing in the world, coupled to negative real interest rates, and high deficit spending by governments gold has a natural tailwind for price appreciation. However, I am most enamored with gold's hidden option potential. Seeing that various cross-border currency stresses and imbalances are only increasing, there is a non-zero chance that gold is one day remonetized. While that is a small chance, it remains a possibility and this gives gold an embedded call option. Should that option value ever be realized the gains should be rather exemplary.
- Got money left over? Then have your wealth managed carefully and safely with an eye on return of principal rather than a return on principal. This is no time for buy and hold, but to carefully weigh the risks and rewards. With the Dow and bonds at all time highs financial assets are as pricy as they've ever been and require a very generous future to distribute more gains to all their holders.
Morgan: I agree with a few, and disagree with others.
High-yield bonds -- yes, they're lurking with danger. Housing -- agreed, when valued against average rents or average incomes, they're by and large a great deal.
Gold, I'm skeptical. With prices surging over the last decade, the gold market appears to be well aware of the policies you describe. As an investor, my worry would not be that high inflation will soon take off, but that gold is already priced for such an event. What's more, gold has a low correlation with inflation over time. It correlates fairly well with A) negative real interest rates, and B) Market panic, either of which are entirely possible going forward, but less likely in a strengthening economy (which you and I seem to respectfully disagree on). And deficit spending is declining rapidly, with deficits as a share of GDP falling by a third over the last three years. I wouldn't count gold out, but I feel the past decade's returns have created a dangerous perception that it is a particularly safe asset, which history is not kind to.
Furthermore, I think the last decade has shown that trying to time the market's ups and downs can be dangerous. Buy and hold, on the other hand, has performed remarkably well. No one consistently buying and holding a low-cost S&P 500 index fund over the last 13 years has lost money -- even in real terms, with dividends reinvested -- yet the number who have lost out by trying to jump in and out of the market is off the charts. The S&P 500 trades at 14.3 times expected 2013 earnings, which is nowhere near the priciest of all time. On a CAPE basis, the index now trades at 22.5 times earnings, versus 19.5 average since its inception in the 1950s. Robert Shiller, who pioneered the method, recently said he expects stocks to produce annual returns of 4% real, or 6%-7% nominal, going forward. Not a king's ransom, but very likely more than one will earn elsewhere.
Let's say I'm an investor who can stomach volatility and has a long-term outlook. Doesn't it make sense for me to sit tight?
Chris: Well, I guess that depends on your definition of 'long-term.' For myself here at the tender age of 50, I consider anything over ten years 'long term' and on that basis I am just not a fan of equities (in general) here for reasons that go well beyond the possibility of a near-term recession.
Warren Buffet once noted that corporate profits are unlikely to grow faster than 6% per year and that when people forget this they are likely to get into trouble. The reason for this is that it is impossible for corporate profits to grow faster than nominal GDP for very long, let alone forever. Today corporate profits are near 11% and the main reason for those excessive profits can be traced to government deficits and reduced personal savings. As you note, government deficits are on the way down and, if that is a structural condition of the next ten years (hopefully!) then we have a serious headwind to corporate profits that will tend to bring them into alignment with historical norms. As a believer in reversion to the mean, I have a pretty strong affinity for the idea that corporate profits are due to moderate.
But more importantly, I have serious doubts about nominal GDP growth even managing to achieve the 6%+ necessary to even support normalized corporate earnings over the next ten years. The reasons are related to structurally and permanently elevated oil prices (new finds are required to keep production up and they average $70-$90/barrel, so this is the new floor) and the still entirely too high debt levels that, although moderated from the recent peak, remain over 350% of GDP. To me this provides sufficient cause for concern that equities might badly underperform both their recent and historical performance over the next ten years. On the basis of cyclically adjusted earnings stocks are anything but cheap here. ...
If one does have a stomach for volatility and a long term outlook I do think there are companies and sectors that make sense, so I am not saying one must be entirely out of stocks, but the broad indexes are very much out of my favor at this time and will remain so until fairly valued and earnings are back in a middle historical range. I'd hate to pit myself against Robert Shiller and his call for 4% real gains in equities, but until and unless nominal GDP roughly doubles from here, I think a strong case could be made for returns near zero over the next 5 -- 10 years.
Morgan: Thanks, Chris.
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