More On Strategy Change And Why We Made It

First, let’s thank John Mauldin for his gracious comments this week in his Thoughts from the Frontline newsletter. John described our recent gathering at Leen’s Lodge in Grand Lake Stream, Maine, and focused on the debate that took place between Jim Bianco and David Blanchflower. We thank John for his permission to post his newsletter on our website. His newsletter can be viewed here.

Not discussed at Leen’s Lodge, but subsequently identified by David Rosenberg of Gluskin Sheff and Associates, is a paper from the Federal Reserve Bank of San Francisco, “How Stimulatory Are Large-Scale Asset Purchases?” by Vasco Cúrdia and Andrea Ferrero. Here is the link. Cúrdia and Ferrero advance the idea that tapering will not be as bad as markets anticipate, because the latest rounds of quantitative easing (QE) did not have much positive effect for tapering to reverse. They have marshaled a robust argument, but their point of view is controversial. It is certainly a perspective that needs to be considered, so we call it to our readers’ attention.

As readers know, we have moved our managed accounts to a position where there is a cash reserve. We have received a lot of email. We answer our clients’ emails first and then continue to address those from our readers.

Readers asked, “Is this stock market a bubble?” We are not so sure. We do not think it is a bubble in the classic sense of bubbles as we know them, e.g., the technology bubble that occurred over a decade ago. It is, however, a highly priced market if the earnings growth rate is going to be low going forward.

Since earnings come out of the profit share of GDP (a consistently and skillfully determined estimate), our concern is that the profit share of GDP is now extraordinarily high by historical standards. In order for earnings to grow, that profit share has to grow even higher (or else total GDP has to grow more strongly than it has been growing).

For lots of reasons that we have articulated in these commentaries, it is not likely that GDP will grow as robustly going forward as it has in previous decades. John Mauldin refers to that fact in his letter this week when he mentions the discussions he has had and the demographic work done by Rob Arnott and his colleague. If the GDP growth rate and the rate of inflation are each going to be 1%-2% (our projected numbers), then the nominal GDP growth rate, which is the combination of the two, is going to be somewhere around 2%-4%. If that is the case, the earnings growth rate is not likely to be much higher than the GDP growth rate itself. This would not always be true; however, it may well be true now, because the starting point for the GDP profit share going forward from 2013 is already at such a high level.

Total GDP includes the profit share and the labor share, and these vary inversely. That is, if the labor share falls, the profit share must rise, and vice versa. Now, however, the labor share is not likely to fall any further, because of the plateauing in the labor area. Job growth is not robust but it is now steady enough to stop the hemorrhaging.

Additionally, higher taxation rates, the imposition of regulations that interfere with productivity, and the likely withdrawal of government stimulus mean that the earnings growth rate from US domestic activity is likely to be a very slow, single-digit number.

But how about the contribution to earnings growth from multinational companies that report those earnings in the US? How much will economic activity grow abroad? We see a lot of evidence around the world, whether in Asia, Europe, Latin America, or Africa, that growth is slowing, and so profits will decline.

The nondomestic profit share of GDP may take a further hit, since the US dollar is likely to become an even stronger world reserve currency when our central bank reaches the pinnacle of its stimulus activities and starts to taper. Eventually the Fed's incremental purchases of government securities will slow and then stop. At the same time, other global players are going in the opposite direction: Japan and the UK, for example, are expansive. The European Central Bank (ECB) is destined to be expansive, too, as soon as it gets through the uncertainty occasioned by the German federal election on Sept. 22 and the German Constitutional Court ruling on the ECB's bond-buying program.

Thus, expansive monetary policies outside the US, in conjunction with a less expansive policy here in the US, will result in a stronger dollar. That will be good for Americans who want to travel abroad or to import, but it will be bad for American companies that have to translate their foreign earnings into US dollars.

When we put all the data together, we come up with a very low and falling earnings growth rate for American domestic and multinational companies. At the same time, those companies now have an aggregate value roughly equal to US GDP, approximately $17 trillion. Only twice before has the ratio of the total market value of US stocks divided by US GDP exceeded the present level. When did that happen? It occurred in 2007 at the pre-crisis peak, and it occurred when the technology bubble hit its peak at the turn of the new century. We know what happened in the wake of both those events.

We're not saying that conditions are as dangerous as they were in 2007. GDP is now higher than it was then; but it has gotten there with less job growth than we would have expected, and while the ratio of stock market value to GDP is now lower than it was at the 2007 peak, it is still very high by historical measures.

Our view remains the same. We are concerned about the level of the market. We are concerned that market prices are discounting an earnings growth rate that we do not expect to be realized. We expect something less. We expect earnings growth to continue to be positive, but not as robust as it has been.

What do you do? One choice is to go into cash. It does not earn anything, but it does not lose you any money. Another choice is to go into bonds.

Government bonds are suspect these days because policy has driven their interest rates to such low levels, even after the backup in yields. The alternative in bonds is spread product. We have identified attractive options in municipal bonds, taxable and tax-free, as we have said many times. We continue to deploy some money in the US stock market and some money in the stock markets of the rest of the world, and to hold some cash in reserve while this adjustment period runs its course.

BY David R. Kotok