5 Things To Ponder: Rising Risk

There are things going on with the financial markets currently that seem just a bit "out of balance." For example, asset prices are rising against a backdrop of global weakness, deflationary pressures and rising valuations. More importantly, there is a rising divergence between sentiment and hard data.

For example, on Thursday the Philadelphia Federal Reserve released their regional survey which showed that manufacturers are the most optimistic in the region in, well, ever. The surge in the "manufacturing" index from 20.7 to 40.8 comes against a backdrop of weaker industrial production during the last 3 months.

However, even more curious was that the surge in the manufacturing survey was offset by Markit's US Purchasing Managers Index which saw a decline to 10-month lows of 54.7 and has, like industrial production, fallen three months in a row. 


Importantly, here are the "key points" from Markit that confirms much of my analysis regarding the impact of a strong dollar/weak global economy combination on U.S. exports.

"Output growth has now fallen for three straight months, taking the pace of expansion down to its lowest since the start of the year. Unlike January, however, this time the weaker rate of growth can’t be blamed on the weather.

Export market weakness holds the key to the recent slowdown, with manufacturers reporting the largest drop in export orders for nearly one and a half years.

There’s some reassurance from manufacturers continuing to boost their payroll numbers at a robust pace, but with backlogs of work showing almost no growth, the rate of job creation looks likely to moderate in coming months unless new order inflows pick up again.

The manufacturing and service sector PMI data available so far point to GDP growth slowing to around 2.5% in the fourth quarter."

While weather can't be blamed yet, it will likely be the main "excuse" in the months ahead as early record snowfall is already impacting economic production.

However, it isn't just the manufacturing data that seems "out of whack." Consumer sentiment about the economy has been surging in recent reports by Gallup, University of Michigan and the Census Bureau.


However, while survey data shows consumers being more optimistic about the economy, the recent mid-term election exits polls told a markedly different story. With a much bigger sampling base than what is used by the University of Michigan, 70% of voters polled stated their biggest concern was the economy. More importantly, that message rang the loudest from Democrats who voted for Republican candidates in traditionally deeply "blue" states.

This weekend's reading list is a smattering of articles covering some of the things that deserve your attention. While my portfolio models are still long biased, I am getting much more uncomfortable about the "risks" that are developing in the markets. You should be too.

1) Goldman Sachs Warns "Multiple Expansion Is Over" via ZeroHedge

"Strategically, the multiple expansion phase of the current bull market ended in 2013. The strong S&P 500 YTD price gain of 10% roughly matches the realized year/year EPS growth of the index. The index has climbed by 17% annually during the past three years as the consensus forward P/E multiple surged by nearly 60% from 10x to 16x.

However, we expect the P/E will contract and the index will slip during the second-half of 2015 as the Fed takes its first step in the long-awaited tightening cycle. Our S&P 500 year-end 2015 target of 2100 implies a modest 5-10% P/E multiple compression to16.0x our top-down 2016 EPS estimate or 14.6x bottom-up consensus earnings estimates.

Every recent investor discussion centers on the question of how stocks will trade when interest rates start to rise. We expect multiples will compress while volatility and stock return dispersion remain low. Our forecast of solid US GDP growth underpins our expectation of low volatility, low dispersion, and low stock returns in 2015."


2) The Risk You Can Control by Haywood Kelly via Morning Star

While Morning Star almost always carries a very bullish spin in their writings, I found these data points to very telling.

"What is our valuation work telling us today? Our valuation lights are not quite flashing red, but they're not green, either. At best, they're signaling mediocre long-term returns for the stock market. Here's where we are as of this writing:

* The Vanguard S&P 500 ETF(VOOtrades just above our estimated fair value based on the valuation of its underlying holdings.

* As of Nov. 18, only 13 stocks out of 1,000 under coverage earn 5 stars, among the lowest percentages of highly rated stocks since we launched the Morningstar Rating for stocks in 2001. (At the market low in March 2009, we had more than 600 5-star stocks.)

* The highest-quality stocks (those with wide Morningstar Economic Moat Ratings) trade near the highest valuations we've seen since we began assigning moatsback in 2002.

* Morningstar investment strategists uniformly believe it's difficult to find bargains today, a sentiment echoed by many of the best investment managers we talk to."


3) Sometimes Things Go To Eleven by John Hussman via Hussman Funds

"As Nigel Tufnel of Spinal Tap described the volume knobs on his guitar amplifier – 'You're on ten here, all the way up, all the way up, all the way up, you're on ten on your guitar. Where can you go from there? Where? Eleven. Exactly. One louder. These go to eleven.'

The chart below presents a slightly different perspective than similar charts I’ve presented over time. Rather than showing discrete instances where a whole syndrome of overvalued, overbought, overbullish conditions has occurred (points with bullish sentiment at extremes, valuations historically rich, prices pushing upper Bollinger bands, etc), the vertical bars show a count of individual components, coupled with additional components that reflect deteriorating market internals. This gives a less binary view of these syndromes. The spikes (such as 1929, 1972, 1998, 2000, 2007, 2011, and the past year) show points when a preponderance of conditions – extreme valuation, lopsided bullish sentiment, overbought conditions, widening credit spreads, and at least some aspects of deteriorating market internals – have been observed in unison. The red line shows the S&P 500 Index (log scale)."


4) Bull Markets Come AND Go by David Keohane via Fiancial Times

"As it currently stands, the current bull is the 4th longest out of 23 in terms of duration, 6th largest in terms of percentage change. It is well beyond both the mean and median based on this data set. There is no reason why the market cannot rally further, even becoming number one in either percentage or duration, or both, of being up on the year, this despite our 'circling the drain' feeling about this especially as the liquidity machine is still pumping in Japan, China and Europe. Given we agree with William Hamilton that the stock markets are 'soulless barometers'; the underlying bid suggests optimism in 2015. As long as the market views the Central Bank intravenous lines as a good thing, we respect the bullish trajectory.

But at some point out, the market will view the medicine as the poison. After all, consistently rising home prices were once also thought of as a good thing. Until the dramatic change. We remain vigilant."


5) Myth: Time Reduces Risk by Ineichen Research & Management

However, if the magnitude of potential loss defines risk, then risk increases with time.

As British economist John Maynard Keynes so famously put it, is that you might not live long enough to experience the long term. The empirical research might be true, but it is of little practical relevance for most investors.

The S&P 500® Index reached a peak in 2007 and recovered swiftly. This is the exception to the rule. It was only possible with unprecedented intervention from government authorities.

Diversification is for those who know what they don’t know. All other investors either don’t know what they don’t know or bought into a potentially false doctrine from which the only cure is substantial losses."


"But if you're gonna dine with them cannibals sooner or later, darling, you're gonna get eaten...” ― Nick Cave

Have a great weekend.

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Lance Roberts

Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Streettalk Advisors, LLC expressly disclaims all liability in ...

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Moon Kil Woong 9 years ago Contributor's comment

I agree that fundamentals and stock prices seem out of whack. They have been like this for several years thanks to the central bank pumping up assets and not the economy. How long they will do this before another downturn will determine how bad off we are when the downturn comes. Of course, once again like under Greenspan the central bank keeps on believing it can prevent a downturn. Really? Do they even read economics books?