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Maybe some GLOOM but not DOOM

I’ve received many inquiries as to my current stance on the market.  I see some potential gloom but certainly not long term doom.

Our current economic situation is characterized by Grisham’s law which states that “bad money drives out good.”  The corollary is: “money flows where it’s treated best.”

Artificially suppressed interest rates have driven money back into real estate and stocks [such was the intent of the Federal Reserve to re-capitalize their member banks].  So far the scheme has worked.  Stocks have re-inflated as corporate earnings continue to grow (growth has been driven primarily by historically low labor and borrowing costs- NOT sales growth).  Residential real estate pricing is mostly up but fragile as somewhere near 20% of mortgages are still underwater.  [see global headwinds below]

Now that large cap markets are stable and the banks have excess reserves…will interest rates rise and drawdown blue chip stock valuations?

The below chart shows the relationship of S&P500 performance (black line, left axis) with price-earnings ratios of both the S&P500 (blue line, right axis) and 10 year US Treasuries (green line, right axis).  [Treasury PE is calculated by taking the inverse of the bond yield, i.e.  a 2.50% Treasury has a PE of 40:  1/.025=40]

Since the Great Recession, the Treasury PE has spiked well above historic norms…paying a low interest rate and thus driving money into stock equities.  [money flows where it’s treated best]  Despite the near zero Fed interest rates, it’s important to remember that an escalating stock market was only possible because corporate earnings have been positive and growing.  Take away corporate earnings and the stock market will dive, regardless of interest rates or Fed policy.  Blue chip stocks are at reasonable valuations if future earnings estimates pan out.  2014 corporate profit growth below 5% would be worrisome.

Interest rates may or may not rise.  Japan has been easing rates and running unsustainable debt for a generation.  There are global headwinds holding back growth which could keep Fed monetary policy extremely loose.  Even if the Fed ends QE, it’s likely that they will continue to roll over their $4 trillion reserves into new debt for the foreseeable future.

Global headwinds holding back growth are:

  1. Aging population
  2. Extreme debt (both public and private)
  3. Government over reach (from crony capitalism in the US to China & Russia trying to expand their borders)

So do I think we’re on the road to economic meltdown?  No.  A 10-20% correction is likely, as part of any business cycle (if corporate profits decline there will be a correction).  A significant stock market drop could even be provoked by the Fed to help them mandate their monetary policies.

I’m optimistic over the long term.  Despite the headwinds, there are robust tailwinds sweeping the US economy.  Five secular megatrends are:

  1. Energy boom- fracking and horizontal drilling technology will be adopted globally and dramatically expand the world’s petroleum and gas reserves.  Low cost energy drives an economy and covers up innumerable inefficiencies.
  2. Automation- will continue to increase productivity and sustain innovation.
  3. Internet connectivity- from the cloud, to social media, to the internet-of-everything:  the information age is just coming out of its infancy and will continue to have a profound impact on efficiency and creative destruction.
  4. Immigration- into the US will provide skilled & unskilled labor to counteract the declining birth rate.  Unskilled labor will particularly benefit service industries that can’t gain efficiencies through automation.
  5. US manufacturing resurgence- small and large scale manufacturing will boom in the coming years due to the convergence of the above four megatrends.

My long term forecast is that the Fed will keep this stagnant economy on track until the above five megatrends kick in.  At which time the megatrends will drive the US economy for a generation.

NOTE: I’m not ruling out a normal 10-20% business cycle correction to the stock market, or multiple corrections for that matter.  I expect turbulence, and as stated in previous articles my current portfolio is mostly in cash.  But I don’t foresee an economic meltdown of the economy.

Treasury price earnings ratio 140522