March 21st, 2015
by John Mauldin, Thoughts from the Frontline
"High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions."
. - The McKinsey Institute, "Debt and (not much) deleveraging"
Never smile at a crocodile
No, you can't get friendly with a crocodile
Don't be taken in by his welcome grin
He's imagining how well you'd fit within his skin
Never smile at a crocodile
Never tip your hat and stop to talk awhile
Never run, walk away, say good-night, not good-day
Clear the aisle but never smile at Mister Crocodile
. - Peter Pan
Written 13 march 2015.
As I sit here on Friday morning, beginning this week's letter, nonfarm payrolls have just comein at a blockbuster 295,000 new jobs, and unemployment is said to be down to 5.5%. GDP is bumpingalong in the 2%-plus range, right in the middle of my predicted Muddle Through Economy for thedecade. US stocks are hitting all-time nominal highs; the dollar is soaring (especially after the jobsannouncement); and of course, in response, the Dow Jones is down 100 points as I write because all thatgood news increases the pressure for a June rate hike. Art Cashin pointed out that, with this data, if theFOMC does not remove the word patient from its March statement, they will begin to lose credibility.The potential for a rate increase in June is back on the table, but unless we get another few payrolls likethis one, the rather dovish FOMC is still likely to wait until at least September. Who knows where rateswill be end of the day, though? Anyway, what's to worry?
Well, judging from the contents of my inbox, I'd say there is plenty going on to make usnervous. We will briefly survey my worry closet today before resuming our series on debt, in whichwe'll encounter Paul Krugman's lament that "Nobody understands debt." Warning:
this letter is goingto be long on charts but hopefully shorter on words - perhaps a little heavy on philosophy. At the endI'll make a few surprise announcements about speakers for our upcoming Strategic InvestmentConference in San Diego, April 29 through May 2. You really want to try to join us for what are goingto be a fabulous few days.
Never Smile at a Crocodile
The following two charts from Bank Credit Analyst found their way to my inbox last week.They are nothing if not the most gaping pair of crocodile jaws I've seen in many a moon. This shouldmake you somewhat cautious in your long-only portfolios. You need to have a plan to avoid a classiccrocodile trap. (And unless you are young, also avoid listening to the Peter Pan song in the YouTube link cited at the top of the letter. Those of us of a certain generation will not be able to get it out of our heads.)
Let's look a little deeper into the payroll report. You have to like what you see on the surface, as 11.5 million more people are working now than at the February 2010 low. What's not as rosy is thatwages increased by only 0.1%, which is understandable when you realize that 66,000 of the 295,000new jobs were in leisure and hospitality, with 58,000 of those being in bars and restaurants. (As JoanieMcCullough pointed out, full employment now means three fingers of whiskey in the glass, neat.)Transportation and warehousing rose by 19,000, but 12,000 of those were messengers, again not exactlyhigh-paying jobs. The oil industry is still shedding jobs, though not as fast as many of us thought itwould. This employment report was very long on low-paying jobs.
Finally, the labor force declined by 178,000 and the Labor Force Participation Rate declined0.1% to 62.8%. You have to go back a full 36 years to March, 1978, to find a similar rate. Yes, some ofthe dropoff was Boomers retiring and some of it may have been due to weather, but it is just areinforcement of the trend that began in 2000.
Nearly all of my kids have worked in the food-service industry at some point in their lives, asdid I, and we are keenly aware how fast those jobs can both appear and disappear in a downturn, not tomention how tips can get a little thinner in tougher times (which prompts me to suggest you think aboutbumping your tip percentage up a point or two here and there. Your waitperson is somebody else's kidwho needs all the help they can get.)
The employment report was bolstered by this week's release of the National Federation ofIndependent Businesses monthly jobs report. All in all, it was a generally bullish report. Then again, thebear in me was struck by how many of the charts seem to be at levels last seen prior to recessions (oneexample below). The chief economist for the NFIB is William Dunkelberg, or Dunk to his friends. Ishot Dunk an email, asking him
"Does it bother you that we are approaching levels (in so many charts)only seen prior to the last two sell-offs?"
He came back with this pithy note:
Yes, I keep trying to think of reasons why we won't fall back, but USA INC is overvalued, stockmarket at a record high but output of USA INC growing slowly and under-performing.Good thing small businesses are not publicly traded. We know the Fed has boosted stock andbond values so those will [eventually -JM] succumb to rising rates. But the NASDAQ is not thesame as the one in 2000, it looks a lot firmer. Lots of stock buybacks, consumer sector may stillbe a net seller of stocks. There is a shortage of risk-free, safe assets, the central banks arehoarding them. ... A "deflation of asset prices" would likely be more like 2000 (financial assetsowned by a few fools) than the housing bubble which cut deeper into the middle class wealthAND jobs. I figure you will sort all this out in one of your brilliant essays. I will be watching :) - Dunk
(Dunk is obviously trying to position himself to get me to pick up his next bar tab, which Ishould hasten to point out can be high, not due to quantity but quality. He is a bit of a wineconnoisseur.)
But he makes a point. US S&P 500 corporate profits are forecast to fall by 4.6% in Q1 and by1.5% in Q2 this year, the first fall in profits for two consecutive Q's in six years, if those forecasts turnout to be true. Falling earnings are not the stuff of roaring bull markets. That being said, the NASDAQof today is not like 2000's.
First, the NASDAQ would have to be at 6900 to give an investor a return in terms of inflation.(It's oscillating around 4925 now.) Remember the secular bear market in 1966 to '82? It was actually1992 before the market reached an inflation-adjusted new high. (Tell me one more time why we think2% inflation is good. When you lose 20% of your buying power in just 10 years, which span hasincluded two deflationary recessions, the 2% inflation premise begins to look a little suspect.) Second,there is actually an E in the P/E ratio for the NASDAQ. Some of the stocks in the NASDAQ 100 areactually on various investors' value lists.
Even so, valuations are stretched. Doug Short combines four different ways to compute valuations (basically, derivatives of the price-to-earnings ratio) into one average. In the graph belowyou will note that there was only one previous time (during the tech bubble that popped in 2000) whenvaluations were higher than they are now. Bear markets and recessions can start from much lowervaluations.
But then again, my friend Barry Ritholtz argues in his March 7 Washington Post column, thatvaluations using other metrics are quite reasonable.
If it appears I'm trying to make you nervous, that's because I am. I'm not suggesting you exitthe market entirely. As the hero of my youth, Lazarus Long (one of Robert Heinlein's recurringcharacters) said:
"Certainly the game is rigged. Don't let that stop you; if you don't bet, you can't win."
I am suggesting you have a well-thought-out, calmly reasoned algorithm that will tell you whento enter and exit specific markets. You should already be out of small-caps, as in a long time ago. Andenergy and emerging markets, etc. Trying to catch absolute tops or bottoms is a fool's mission, but witha methodical program you can avoid large drops and, just as importantly, latch onto big runs. It takes awell-reasoned system and discipline. You or your advisor should have both.