Friday, December 27, 2013

Third Quarter Growth: Please Ignore The Blip

Investment Thesis: Bonds are oversold, and stocks remain attractive.

Bond prices are falling while stock prices are rising. This reflects the market’s bullish interpretation of the 4.1% annualized third quarter growth revision. The market has taken that single data point and extrapolated it into a faster recovery. Faster recovery would mean higher corporate earnings growth, and higher inflation. Hence, stocks up, bonds down.

The market is wrong on both counts. The third quarter growth number was a blip in a long series of blips in both directions. The signal to noise ratio is low and anomalous. Most other signals point in the opposite direction: low money growth, declining money velocity, low nominal and real growth, low inflation.

Money supply growth has been falling for the past two years (from 10.5% to 5.5%, YoY), while velocity has continued its long downward march. Inflation remains dangerously low and nominal growth is stalled at a scarey 3.4%. Metals are capitulating, not an inflation signal. There is nothing on the dashboard to signal faster growth, besides the revised 3Q number.

Quarter-on-quarter growth has been very volatile, and continually reverses direction. It means nothing unless sustained, which I don’t expect. While it’s hard to get excited about 3% bond yields, there is nothing to suggest that yields will go higher; they are more likely to decline once the bleak reality asserts itself.

The stock market would seem to lack a compelling inner logic. It is forecasting both low inflation and strong earnings growth, which is an unlikely combination. I am expecting low inflation and modest earnings growth. The topline will remain under pressure from low nominal growth, while the productivity gains from the recovery are diminishing in scale.

My bull call on the Dow is not driven by earnings growth, but rather by the fact that one is still being paid more to own stocks--even at these prices--than to own cash or bonds. The forward earnings yield on the S&P is now 6.1%, which is twice the yield on the ten-year. Hence I see the S&P as still being fairly priced; not a screaming buy as in 2009, but still your safest bet.

I expect negative earnings surprises going forward, for the reasons given above. So, for example, if S&P earnings were to have a flat or negative quarter, prices would decline. That is the risk at this price-level. But I see nothing that would cause a sell-off, and there is still upside.


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