Early Signs of a Recession?

I’ve run across a couple of charts lately that make me a little skittish about the economy. The first is this look at the percentage change year over year in US Business sales:

7.14.15 Business Sales

Next is a look at Wholesaler sales and wholesaler inventories divided by sales:


Manufacturing orders are also solidly negative year over year, consistent with past recessions:

Factory Orders YoY

Recessions are notoriously hard to forecast. As economist Paul Samuelson famously wrote, “Wall Street Indexes predicted nine out of the last five recessions! And its mistakes were beauties.” Nevertheless in a financial world where assets are seemingly driven by central banks around the world, I wonder if we might start to see more signs of an impending recession without the market reacting initially as the fed put seems alive and well.

The above charts, combined with the market’s valuation levels, could certainly make for an interesting period going forward.


Don’t be a Portfolio Patriot

As the graphic from the Wall Street Journal below shows, the US stock market has been a star the past five years compared to the rest of the world.

5 Year Global vs US Stock Annualized Returns

Not surprisingly, many investors are now overweight US stocks. This is a mistake on a couple levels. First, as I’ve discussed before, the US stock market is currently expensive based on valuation metrics such as Market Cap to GDP or the Shiller P/E ratio. Not only is the US market expensive relative to its own history, but it’s very expensive compared to the rest of the world. The US economy makes up nearly 20% of global GDP, yet the US stock market makes up nearly half of global stock market capitalization. The table below, produced by Mebane Faber, ranks global equity markets based on an average of 4 cyclically adjusted valuation metrics (price/earnings, price/book value, price/dividends, and price/free cash flow). As you can see, the US ranks near the bottom of the table as one of the most expensive markets globally.

all-metrics Global Valuation

Studies have shown that diversifying into international equities can improve risk adjusted returns. Additionally, diversifying internationally can help investors avoid disaster that occasionally strikes an individual country’s stock market. If you’re currently heavily weighted towards the US in your portfolio, now might be a good time to look at getting more exposure to cheaper international markets.

For further info on avoiding the home-country bias in your portfolio, check out Patrick O’Shaughnessy’s piece here or search for some of Mebane Faber’s books and posts which also do an excellent job.

2014 Year End Market Valuation Update

Last year I looked at a few different valuation metrics that showed the US stock market  was trading at lofty levels. Following a strong year in which the S&P 500 returned nearly 14% I thought i would update some of those metrics to get an idea of where the market is at going into 2015.

Shiller P/E Ratio

As we head into 2015 the Shiller P/E stands at nearly 28, compared to its level of ~25 at the beginning of the year.

Shiller PE

Market Capitalization to GDP:

Market Cap/GDP has also spiked up to levels last seen in the tech bubble of ’99:


Tobin’s Q Ratio:

Finally Tobin’s Q has broken out from approximately 1 a year ago to 1.18 today.


Moving Forward

While these valuation metrics have had strong correlations with ten-year forward returns in the market, they tell little in terms of short-term timing. Indeed they all suggested poor future returns at the beginning of last year and the market recorded a nice gain in ’14.  That being said, with all these metrics reaching levels last seen at or above market peaks, caution still seems the prudent course of action.

Where is the Investor Euphoria?

After a huge gain in 2013, US equity markets posted fantastic two and five year return numbers. Somewhat surprisingly, the average investor seems to be rather apathetic given the huge run up in the market. For instance, CNBC core viewership hit two decade lows in 2013. Barron’s polled advisors and while the majority think stocks are the place to be in the next twelve months, they weren’t exactly predicting home run returns. So where is the enthusiasm? Maybe the Fed’s flood of liquidity and low rates have led people to temper their expectations. Perhaps it’s the fact that investors have been burned twice in the past 15 years or that many investors have only recently surpassed previous peaks in their net worth. Maybe it’s the public’s exhaustion with political bickering or its distrust of the market and its major players. Whatever the reason, the euphoria of past bull markets doesn’t appear to be present.

Frank Martin, founder of Martin Capital Management, had an interesting take on the subdued sentiment: “The market crowd’s message is particularly insidious today because it lacks the tympanic rumble of a typical bubble. It is a herd of the needy, not the greedy. The effect is the same, but without the telltale clamor.”

David Einhorn, manager of Greenlight capital, noted the lack of enthusiasm in his Q1 letter to investors: “We are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it. In our view the current bubble is an echo of the previous tech bubble, but with fewer large capitalization stocks and much less public enthusiasm.”

Despite their apparent lack of enthusiasm, average investors’ attitude toward the market does not seem to coincide with the level of risk they are taking in their portfolios. Russ Koesterich had a nice article this week showing investors exposure to risk assets such as stocks, corporate bonds, and mutual funds is at its highest level since the third quarter of 2000. Retail brokers have been reporting large increases in trading volume and TD Ameritrade revealed that investors’ allocation to cash at is at its lowest level since September 2007. Finally, margin debt has exploded in the past year and as a percentage of GDP is basically at the same level it reached at its peaks in 1999 and 2007.

Tech stocks were all the rage in the late ‘90’s and housing was the topic du jour before the financial crisis in 2008. No single sector or asset class dominates the headlines today but there is a noticeable clamor for yield. For months advisors profiled in Barron’s have touted their ability to put together a portfolio generating yield via REITs, MLPs, high yielding bonds, and dividend paying stocks. Not exactly something an investor is going to brag about at cocktail parties and backyard BBQs.

In his last quarterly letter Jeremy Grantham predicted the US market would work its way 20-30% higher, with international and emerging markets performing even better. Maybe that would bring the real animal spirits back into the public. Do we need to see the euphoria before the market could drop to lower valuations? Does the lack of current enthusiasm indicate that stocks have more room to run? I have no clue in the short run but the mismatch between investors risk exposure and their attitude towards the market is interesting.

Examining the Appeal of Gold

Gold is a challenging asset to evaluate. When you cut through all the narratives and superstitions around gold, I think its investment potential boils down to two distinct aspects of the metal. First, gold is a commodity that has no tangible value and produces no cash flow or income. Second, gold has served as a store of value or currency over thousands of years. Most people in the investing world seem to view gold through one of these two lenses and that can lead to very different opinions on the metal.

Gold as a store of value or alternative currency

In a world where central banks seem to believe they can print their way out of any economic problem, it’s no surprise that many investors are looking for an alternative to fiat currencies. Given its extremely long history as a currency and store of value many believe that gold is the ideal solution to much more easily manipulated fiat currencies.

In his 1978 work The Golden Constant, Roy Jastram examined centuries of data and found that gold maintained its purchasing power over very long periods of time. Prior to 1971, gold was generally linked to money (if not money itself) and thus it generally lost purchasing power during inflationary periods, thus proving a poor short term inflation hedge before 1971. However, as gold is no longer linked to money it’s possible that it may serve as a better short term inflation hedge in the future.

What makes me nervous about the price of gold today is the move the metal has made in the past decade relative to inflation. The chart below shows the price of gold indexed to US inflation (as calculated by CPI) going back to 1967. In inflation adjusted terms, gold appears to have gotten ahead of itself the past few years, even after its recent decline.

Gold divided by CPI

A similar attempt was made to compare gold to US inflation dating back to 1800 in the chart below, which again depicts a high inflation adjusted price of gold today. long_term_gold_price_CPI_adjusted_1800_2013

However, some people constructive on gold believe that CPI and other official inflation measures understate true inflation. Economist John Williams attempted to create a more accurate picture of inflation in producing his shadowstats inflation measure, which attempts to measure inflation in the same manner it was calculated in 1990. Adjusting gold for this inflation measure presents a very different picture of its current price:chart-gold-1

Unfortunately if you compare that shadowstats inflation measure to other real assets you get some strange results and it loses credibility. For instance, calculating real housing prices utilizing the shadowstats inflation measure makes U.S. housing prices in 2005 look cheaper than at any time from 1980-1995.

If gold is truly an alternative currency then perhaps it should trade as some relative constant of US monetary supply. In terms of monetary supply it would appear gold could trade much higher:monetary_base_M0_vs_gold_price_1940-2012

Again, gold’s a tough thing to analyze. As a store of value gold has outrun inflation in the short run, potentially setting it up to fall in real terms. As an alternative currency gold may be undervalued relative to the expansion in US monetary base. 

Value investors supporting gold

Kyle Bass said last year, “I am perplexed as to why gold is as low as it is. I don’t have a great answer for you other than you should maintain a position.”

Seth Klarman discusses problems with gold as well as its appeal. In 2011 he stated because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and much higher interest rates seem like necessary hedges to maintain. Gold is unique because it has the age-old aspect of being viewed as a store of value. Nevertheless, it’s still a commodity and has no tangible value, and so I would say that gold is a speculation. But because of my fear about the potential debasing of paper money and about paper money not being a store of value, I want some exposure to gold.”

More recently, Klarman has reiterated the need for taking a position: “There will be a day when the world looks very different, so when we rack our brains – how we might protect ourselves – we’re looking for cheap optionality. Rates will be higher at some point. I don’t know where rates would be if not for all this QE and bond buying and expansion of the Fed balance sheet. So what we come up with over and over is gold, the one place you probably want exposure.”

Back in 2012 Jean Marie Eveillard stated “gold is a substitute currency, and I look at the enormous amount of paper that continues to be issued by the Fed and the ECB, and as long as they keep printing enormous amounts of paper, I think gold cannot be overvalued.  There is one individual who, in terms of the backing that would be necessary for the enormous amount of paper that has already been issued, thinks that as of today the amount of gold should be at $15,000 an ounce.”

Value investors not supporting gold

In a 2011 interview with CNN Money Bob Rodriguez stated “When I look at gold, I have a hard time determining its value. There are certain areas of the world that love it for various reasons. It has been a store of value at various points in time. But if you compare gold and oil, which is more productive? That would be oil. Which has a longer life expectancy on this earth? Gold. One commodity does not have a diminishing supply, while the other one does. So I think energy is the better store of value.”

Warren Buffet published one of the more stinging critiques of gold in his 2011 letter to shareholders:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be $9.6 trillion. Call this cube pile A.

“Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

“A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.”

Buffett makes one of the strongest arguments against gold from the lens I mentioned earlier: gold is a commodity with no tangible value and produces no cash flow or income. If you inserted ‘US Dollars’ into Buffett’s letter in place of gold his message would remain the same. Echoing this critique of gold, Donald Yacktman has said he’s much more interested in owning strong businesses like Coke rather than gold.

Final Thoughts

I don’t think there’s a clear answer to whether or not the typical investor would find gold an asset worth holding. On the one hand I think it’s self evident that an investor would do much better owning productive assets over any store of value over very long periods of time.

But for investors worried about central banks printing money and the current valuation of most asset classes, gold is one of the only assets with such a long history as a store of value and alternative currency. While easy money programs from central banks around the globe have produced very little inflation to date, it’s possible that the price of gold could react in anticipation of future inflation. So while I worry that gold may have gotten ahead of itself as a store of value, if further easing leads to higher inflation down the road the real price of gold may not be as high as it appears.

2014 Forecast

I want to start by acknowledging that short-term forecasts are worthless. If you had a dream that the market was going to be up 20% next year or you threw a dart and came up with an 18% return forecast I’d say you have just as good a chance at being correct as Wall Street professionals whose career is based on attempting to forecast. Nevertheless people like the false sense of security that comes from an expert prognosticating the future and thus the we continue to hear forecasts. So with that said, I figured I might as well come up with a forecast of my own.

Barron’s published Wall Streets’ forecasts for 2014 a couple weeks ago. The consensus view is for the market to increase slightly over 11% with profits increasing 9% and GDP growing at 2.7%. Sounds a lot like 2013 forecasts to me. 

I think i’ll roll with some of the updated economic forecasts and predict GDP growth in the low 3% range. However I don’t think the improved economic growth will translate into improved profitability. As the economy expands and the unemployment picture improves, I think companies will find that they are no longer able to wring out higher profits via low labor costs. While I think that the market starts the year up as momentum for 2013 initially carries over, once profit growth fails to materialize the market will begin to sputter in the second half. Thus I predict the market will initially climb 5-15% but ultimately finish the year in the red with a loss of 5%. My background in BS might not be as good as the forecasters on Wall Street but 60% of the time it works every time 😉

Happy New Year

Links of Interest

A nice look at investors’ poor timing and whether it’s possible to come up with a sensible market timing approach based on valuations:


Lots of good stuff on the stock and bond market here from Sitka Pacific Capital Management. Essentially they appear to be attempting to put into practice what the first article examines with a valuation approach to investing in the market. Probably been a rough year given the large exposure to precious metals and miners in their latest allocation.


Owners vs Renters – A quick look at holding periods of equities:


Finally here’s a couple of links to writers who aren’t quite as concerned about the market’s valuation: