By David Stockman, Budget Director under President Reagan and author of the bestseller, The Great Deformation: The Corruption of Capitalism in America. This article originally appeared on David Stockman’s Contra Corner.
In December 2007, Barron’s published its outlook for the year ahead, and Wall Street strategists were waxing bullish. Notwithstanding the advanced state of disarray in the housing and mortgage markets, soaring global oil prices and a domestic economic expansion cycle that was faltering and getting long in the tooth, Wall Street strategists were still hitting the “buy” key. In fact, the Great Recession had already started but they didn’t have a clue:
Against this troubling backdrop, it’s no wonder investors are worried that the bull market might end in 2008. But Wall Street’s top equity strategists are quick to dismiss such fears.
Indeed, with the S&P 500 at an all-time high of 1460, the dozen top Wall Street prognosticators surveyed by Barron’s anticipated still more index gains during 2008:
… the dozen seers we’ve surveyed all have penciled in higher stock prices in 2008, although their estimated gains vary widely, from 3% to 18%. On average, the group sees the Standard & Poor’s 500 at 1,640 by the end of next year….
That 12% gain didn’t happen! The market ended 2008 in an altogether different place—that is, about 45% lower at around 900. And, as is shown below, it still wasn’t done—until the capitulation low was reached in early March 2009 at 675.
In truth, this Barron’s article needs no time stamp. Every one of the arguments being made today were trotted out in almost identical form then. Front and center was the usual canard that the market is cheap on a forward PE basis. For what was surely the 17th time in as many years, Goldman’s Abby Joseph Cohen claimed the market was trading at well below its long term multiple:
….the S&P 500 trades today at just 15.6 times average 2008 estimated earnings — well below the average P/E of 18.6 times earnings during periods when inflation was at similarly muted levels in the past 57 years, notes Goldman’s Cohen.
There were three big clouds in Cohen’s perennially bullish crystal ball. First, inflation didn’t stay so benign. During the next year oil soared to $150 per barrel, bringing the CPI up by 2.9%.
Secondly, 2008 earnings did not come in at $100 per share per the Wall Street hockey-stick, but plunged to $55 on a so-called “ex-items” basis (excluding one time or non-recurring expenses which continuously seem to recur anyway). And actual 2008 earnings for the S&P 500 came in at just $15 on a honest GAAP basis as reported to the SEC under penalty of criminal charges for deliberate misstatement.
But most importantly, Cohen’s 57 years of historical benchmarks were irrelevant. That’s because these historical cycles reflected a reasonably vibrant mechanism of “price discovery” based on traders assessing, weighing and perpetually recalibrating the incoming facts from the macro-economy and individual company performance. But by December 2007, price discovery had long ago been destroyed by the Greenspan era policy of financial repression, wealth effects, and the Fed’s “put” under the market averages.
Like now, the short-interest had been driven out of the market and, as is evident from the chart above, the fast money crowd had been handsomely rewarded for buying the dips—confident that the Fed had their backs. Indeed, the bullish case was overwhelmingly pinned to the expectation that the Fed and other central banks would not let the economy falter, and that a new round of interest rate cuts and other stimulus initiatives would keep the party going:
THE STREET’S BULLISH consensus is particularly impressive considering that all 12 strategists also take a dim view of the U.S. economy’s prospects and expect the Fed to keep cutting interest rates to spur spending.
… Although Wall Street was bitterly disappointed by the Fed’s decision Tuesday to cut interest rates by just a fourth of a percentage point instead of a half-point, more rate cuts could be on tap in 2008, both in the U.S. and Europe. In the meantime, the U.S. central bank took a bold step Wednesday to ease the global credit crunch by announcing plans to offer up to $40 billion in special loans to banks in coming days. Central banks in Europe and Canada are planning similar measures.
Meanwhile, the facts on the ground in the financial markets were getting worse by the day. Stock buybacks and cash M&A deals were at peak historical levels, thereby adding further momentum to a market that was already trading upward on a one-way basis. Likewise, the junk bond market had exploded to new heights, as had issuance of other dodgy late cycle securities like “cov lite” term loans, pay-in-kind junk bonds and collateralized loan obligations (CLOs), which amount to leveraged funds which issue debt against debt.
And this was to say nothing of Wall Street balance sheets which were bloated with giant inventories of sub-prime and other low grade mortgagees waiting to be sliced and diced into CDO’s, CDOs squared and other toxic exotica. All of this financed on the margin with “hot money”—that is, repo and unsecured wholesale credit.
Beyond this, the LBO financing market was totally out of control, sending a tsunami of cash into the stock market to buy out public companies at absurdly high double digit multiples of cash flow. In the Great Deformation, I tracked 30 mega-LBOs during this period which were taken out at a combined market value of about $500 billion, causing $375 billion of fresh cash to flow to stockholders. Like today, the latter was funded with massive new layers of junk bonds, PIK bonds, second lien loans, and other bank credit.
The foundation underneath the market was rotten because honest price discovery was no longer operating. The momentum from vast inflows of underpriced debt and dip-buying by hedge funds betting on the Fed’s “put” caused the actual fundamentals to be largely ignored. For instance, during late 2007 the reported LTM earnings per share for the S&P 500 was about $75. That means the actual PE multiple was 19.5X as the Barron’s year-end revelers talked up the market for the year ahead. It was sitting, therefore, at a dangerously high plateau even by historic standards.
When the market plunged by nearly 50% during the latter months of 2008 and early 2009, the speed and violence of the decline was striking evidence that monetary central planning has doubly destructive effects on the financial markets. In the first instance, it causes bubbles to inflate to exceedingly artificial and excessive levels owning to the inflow of cheap cash and momentum chasing bids from the Fed-following fast money. But in the process it also vaporizes the braking and checking mechanisms—such as short-sellers buying to harvest their gains—that allow markets to correct without collapsing.
A case in point is the Russell 2000, which had climbed a 5-year wall of worry from about 350 to 820 as of late 2007. But when the market broke hard after the Lehman event, nearly the entire 20%/year compound gain was ionized in just 15 violent trading days during the next several months. In short, by turning financial markets into gambling casinos, the central banks have sown the seeds of vast and recurring financial instability. Bubble tops get more and more exaggerated. Bubble collapses become increasingly swift, violent and overdone.
After six years of ZIRP, QE, and generally far more extreme monetary expansion than occurred in the run-up to the 2008 financial crisis, every one of the bubble top symptoms described above and completely ignored by the Wall Street bulls cited in the timeless Barron’s piece have reappeared. If anything, the carry trades, vast chains of asset re-hypothecation and momentum based speculation is far more extreme than last time around; and the broad market is also once again precariously positioned at the tippy top of its historic trading range.
The honest LTM earnings of the S&P 500, for instance, are now about $100 per share, adjusted for a pension accounting change that did not exist in 2007. So we are right at that very same 19.5X valuation that was posted at the top last time around. But this replay is occurring in a market that is far more precarious—that is, it is faced with interest rate normalization in the years ahead and that will cause earnings to fall. Also, it is a market that reflects profits rates on income and GDP that are off the charts historically, and are far more likely to regress to the mean than stay perched at their current nosebleed levels.
And most of all, the business cycle today is already 60 months old, but unlike 2007 it is far weaker and less stable. Indeed, unlike the 2002-2007 credit-fueled recovery, this “peak debt” constrained expansion has not even recovered its previous cyclical high based on economic fundamentals like breadwinner jobs, real capital investment in plant and equipment, and real household incomes. So now might be a good time to re-read the Barron’s piece from late 2007. Its real message, as it turned out, was “look-out below!” By David Stockman. This article originally appeared on David Stockman’s Contra Corner.
The S&P is up nearly 200% from March 2009. Yet the cardinal measures of Main Street economic health have stagnated. Read…. David Stockman: Why The Market Is Heading For A Fall
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