Since pulling back somewhat during the bond market selloff, stocks have had a furious rally, with many stocks and major indices at multi-year or all-time highs. I reluctantly sold Zillow yesterday, a stock I’ve publicly cheerleaded over the past couple years, as it’s now trading at around 10x next year’s sales. That’s a valuation that may make sense around this time next year, but in a somewhat frothy environment was too much risk for me to carry at the moment, even with the generous cushion I give the company and its management.
It got me thinking that maybe all asset prices have gotten ahead of themselves, with stocks possibly up too much too soon, and bonds pricing in a tightening path that may turn out to be too aggressive. If that’s the case, then instead of thinking about 2014 risks (we’re already priced for a bullish 2014), we have to stretch and start thinking about 2015-16. And when doing so, I was more cautious than I thought I’d be.
It’s taken us so long to get over the trauma of 2008 that we may forget just how long this recovery has already lasted. We’re 2 months away from the 5-year anniversary of Lehman weekend. By 2015-16, it’ll have been 7-8 years, a good-sized recovery cycle. Courtesy of Aswath Damodaran, here are the years for peak S&P 500 earnings going back to the 1960’s:
-1969, 1974, 1981, 1989, 2000, 2006
The average length of time between peaks has been 7-8 years — the shortest was 5 years and the longest was 11. I highly doubt that 2013 will turn out to be the peak year for earnings given the ongoing housing and employment recovery, but 2014? That will have been 8 years since the last peak. By 2015, 2016 we’re talking 9, 10 years. This may not be a normal business cycle, but the odds favor some sort of earnings peak in 2014-16.
What could cause such a peak? The scenario I find most likely is one where fiscal and monetary policy tighten faster than the private sector can handle.
As much as we’d like to think we’ve evolved into a new economic age in the 21st century, recoveries are still driven by autos, housing, and household borrowing. Looking at this chart of auto sales, maybe there’s still some pent up demand that could result in a brief overshoot, but we’ve more or less normalized.
The area for most growth optimism remains housing, where housing starts/building permits could continue to grow strongly into 2015, maybe even 2016.
But where I struggle is the household borrowing/federal budget outlook. Until now, we’ve been going through what Ray Dalio has called “the beautiful deleveraging.” Housing and autos have grown, which has been offset by a falling budget deficit. Household debt is no longer shrinking, though the deficit is now shrinking aggressively.
The blue line is household debt growth, and the red line is the budget surplus/deficit inverted (it shows 7% of GDP, though the CBO is projecting 4% of GDP for 2013.
Looking at page 8 of that CBO report, it shows the 2013-2015 deficit forecast is 4.0%, 3.4%, and 2.1% (of GDP). Should tax revenues recover faster than expected and Congress continue to cut spending, we could be running a surplus by 2015.
Thrown into that mix is a Federal Reserve with many members that are uncomfortable with continued large-scale asset purchases and 0% interest rates, and will use any better than expected economic news to tighten monetary policy sooner than expected.
So here’s the scenario I see for 2015: better than expected housing growth in 2013-2014 leads to aggressive tapering in 2014 and rate hikes in 2015. Household debt growth remains sluggish relative to past recoveries. The House GOP continues to refuse to spend more as the economy recovers, throwing the budget into a surplus in 2015. By that point, President Obama and candidate Clinton, looking to play to downscale whites and selling the fiscal bonafides of the Obama administration, declare mission accomplished on the budget heading into the 2016 election, and we get a mild profits recession in late 2015-16.
Maybe it seems silly to project that far out, but with stocks up here, I think you have to look beyond the next 12 months if you’re looking to buy.