What If the Recovery Is Scorching?

Friday's unemployment numbers weren't great, but U.S. GDP grew at an annualized rate of 3.5% in the third quarter -- the first positive growth in 12 months and an indication that the recession ended sometime during the third quarter. There are even some smart people who believe we will witness a strong recovery. It's time to reexamine my (bearish) assumptions and ask: "What would it mean for investors if we have a blistering recovery?"

Mining history for clues
With the publication of his Q3 Commentary in mid-October, value manager Bill Miller staked out his position firmly in the optimists' camp:

There have been 14 10-year periods where stock returns have been negative, including this one. In every one of the previous 13, the subsequent 10-year returns have exceeded 10% real, about 50% more than average, and more than double the return of government bonds. So every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and they have beaten bonds every time by an average of 2 to 1, yet investors can't put money fast enough into bond funds, and continue to redeem equity funds.

Miller is absolutely right that periods of poor stock market returns are generally followed by ones characterized by strong returns. If we didn't have the wealth of historical valuation data that we do, Miller's approach of looking at stock market returns in isolation would be entirely defensible. Plumbing that data, however, leads to a different conclusion.

Robust economic growth: possible. Robust stock gains: unlikely.
Another economic bull, Jim Grant, recently wrote in The Wall Street Journal: "Our recession ... does bear comparison with the slump of 1981-82." Not in every respect: The cyclically adjusted P/E (CAPE) multiple of the S&P 500 spent that entire recession in single digits (the CAPE is calculated based on a moving average of prior 10-year inflation-adjusted earnings) -- leaving quite a bit of room for the multiple to expand. By contrast, the S&P 500 is currently valued at 19 times its cyclically adjusted earnings -- 16% above the multiple's long-term average.

I think the argument for a robust recovery is plausible (although I don't personally subscribe to the notion). The trouble for equity bulls is that such strength will be sorely needed just to support current valuations, let alone spur further stock market gains. That holds for the broad market and for many individual names, too. Approximately four in 10 stocks in the S&P 500 index, representing nearly a third of its float-adjusted market value, are currently trading at a price-to-earnings multiple above 16, including:

*At Nov. 5, 2009
Source: Capital IQ (a division of Standard & Poor's) and author's calculations based on data from same.

My concern is that the closest comparison to the U.S. lies not in our past but beyond our borders. Japan's extraordinary 1980s real estate and stock market bubble were followed by a "lost decade" of low growth and false starts, from which it has yet to fully emerge.

Wood chops down exuberance
Christopher Wood, the CLSA strategist who predicted this phenomenon in The Bubble Economy (and warned about the massive risk in the U.S. mortgage market in 2005), now believes there are "legitimate comparisons with post-bubble Japan." Furthermore, "if the U.S. is truly in a deleveraging cycle," Wood expects American institutional investors -- who remain overweight equities -- to rebalance their holdings away from stocks into government bonds, as their Japanese counterparts did. No need for an advanced degree in finance to figure out that this would put downward pressure on stock prices.

How to position yourself
As we close in on the 20-year anniversary of the event, Japan's Nikkei 225 stock index stands at just a quarter of its December 1989 high, despite four 50%-plus rallies. Do I expect the S&P 500 to be around 400 -- one-fourth its October 2007 high value -- in 2027? Not by any stretch of the imagination (excluding a biblical disaster). However, the market's current overvaluation suggests it is imprudent to be overweight U.S. equities right now unless your portfolio is made up of carefully chosen stocks that are trading at or below their intrinsic value. I agree with Wood: The odds favor a correction over the next six months, at which time investors who have kept some cash on hand will be able to take advantage of lower prices.

The U.S. is facing a number of significant structural challenges. Global Gains co-advisor Tim Hanson asks investors to read this because the dollar is doomed.