The Market Is Pricing Perfection, But Heading For Recession

December 19, 2013

Today we note that:

·         The US economy is tipping back into recession again

·         Corporate profits are at record highs and set to fall

·         Stocks are extremely overvalued

All of these add up to a real problem for long-term stock investors today. The classic method of valuing stocks, the P/E ratio is comprised of market cap relative to earnings.

If earnings are at record highs today and stocks are already overvalued, how high will P/Es be when earnings begin to contract with stocks at these levels?

My point with all of this is that based on valuations and economic conditions, now is not the time to be loading up on stocks. There will be plenty of opportunities such as NVDA and NDRO which we’ve already invested in, but overall, I would not be heavily buying stocks at these levels especially relative to earnings.

Speaking of earnings, let us now move to #2 on the list of items I listed at the opening of this issue: the recent collapse in revenues and earnings at economically sensitive firms.

We’ve seen a recent spate of terrible results from corporate America.

In the last few months alone we’ve seen disappointing earnings at:

·         Caterpillar (global machinery)

·         Microsoft (software)

·         Google (search engine ad revenue)

·         Chevron and Exxon Mobil (oil)

·         Discovery (credit cards)

·         Amazon (online retail)

·         Charles Schwab (brokers)

·         Wynn Resorts (casino)

There are dozens and I literally mean dozens of ways to craft earnings to be better than reality. You can write down assets, alter depreciation methods, manipulate bad debt expenses in accounts receivables, game the closure of deals, take one time charges, utilize derivatives and mark to model valuation of assets, etc.

Indeed, a study performed by Duke University found that roughly 20% of publicly traded firms manipulate their earnings to make them appear better than they really are. The folks who were surveyed for this study about this practice were the actual CFOs at the firms themselves.

In this sense, it is safe to that 2013 earnings, as poor, are they are, have been “massaged” to look better than reality.

Indeed, we get confirmation of this from revenues misses. As I mentioned a moment ago, earnings can manipulated any number of ways, but revenues cannot; either money came in or not.

With that in mind, we’ve in the last few quarters we’ve seen revenues misses at:

·         Merck (big pharma)

·         Molson Coors (alcohol)

·         Clorox (cleaning materials)

·         US Steel (steel)

·         McDonald’s (fast food)

·         3M (conglomerate)

·         GE (conglomerate)

This brings me back to an earlier point, that profits and earnings are likely peaking. Net profit margins today are at all-time highs. There is virtually nowhere to go but down here.

Finally, I want to draw your attention to the massive cash hoards value investors and wealthy individuals are sitting on.

Warren Buffett, arguably the greatest value investor of the last 100 years, is currently sitting on a cash hoard of $49 billion. This is an all-time record for Buffett. And it’s a strong indication that there are few great deals in the market today.

Few investors understand inflation as well as Buffett (though his views on Gold are confusing for many). But Buffett is a master of beating inflation. He’s well aware that by sitting on cash today with interest rates at zero he’s “losing money.” The fact he’s willing to do this rather than invest in stocks should be a major warning to investors that there is a dearth of great value opportunities in the markets today.

Buffett is not the only one.

Mega-private equity firms, Fortress and Blackstone have been urging their clients to get out of the market.

Moreover, a recent study by American Express and Harrison Group has found that the wealthiest 1% of clients has been shifting rapidly to cash with their savings rates soaring from 34% to 37% last quarter.

Bank of America had similar findings of its millionaire clients with 56% of them stating they have a “substantial” amount of their assets currently in cash.

This just confirms my concerns that the market is currently offering few opportunities for long-term deep value investors.


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