Cautious on Stocks – Why Stocks Are Only Chipotle Cheap

by Byron on November 6, 2011

Why I Cautious…

I’m more than cautious, I’m bearish.  The reason is simple and can basically be summed up in one blog post with a couple of links.

First, the “stocks are historically cheap” argument is only partially true.  Stocks are mildly cheap, not extremely cheap, if you examine the last thirty years.  Thirty years spans the entire career of a 55 year old.  This probably has a lot to do with why you hear so much of the “historically cheap” argument.

Even for the last thirty years, I like to think of stocks as Chipotle cheap, not McDonalds cheap.  Chipotle is far less expensive than a good steak, but Chipotle costs twice as much as McDonalds.  The ingredients are twice as good, perhaps.  The price is justified.  But what if they started using McDonalds ingredients.  The price probably wouldn’t be justified.

Am I cryptically saying there are going to be shortfalls in corporate profits, a looming recession, or other “ingredient” problems?  Who knows?  I’m just saying stocks could get cheaper from here.  Cheap over the last 30 years is not the same as cheap all-time.  We are closer to average all-time.  Many of you have seen the chartoftheday.com chart reflecting long-term S&P 500 PE Ratio.  It’s here, among other places.  Crestmont also has similar charts.

Second, there is a massive consumer debt overhang, and consumers make up 70%+ of the economy.  The consumer simply cannot afford to fuel the economic consumption engine any longer.  One of two things happens.  Consumers spend less, which is not good for the economy.  Consumers default on their bills, which is not good for the economy.  See the chart of household balance sheet problems from PragCap.

(That leaves government, exports and capital spending by businesses.  The government is a wild card.  Everyone continues to suggest spending can, should and will be reigned in.  But every less dollar spent by government costs votes for some politician.  Last I looked, politicians give up votes like a lion gives up a jugular.  This is the fact that will keep the United States out of the abyss.  But government spending alone can’t do it.  Businesses are spending, to some degree. But businesses aren’t really spending on people; they’re spending on technology and capital equipment.  They are doing more (or setting up to do more) with less people.  This is good for companies that benefit from capx.  Not so good for the rest.  Oh, and exports?  Whatever.  Maybe if the dollar can get even cheaper.)

The debt overhang issue, and stocks at average historical price to earnings ratios, isn’t enough to be bearish.  It is enough to be cautious.  You then have to take those cautious eyes and look intently for catalysts.

The market, judging by price action over the last 3-6 months, is pricing in a non-cataclysmic event in Europe.  What it’s pricing in is a lot closer to non-issue than complete breakdown.  This says Europe is far more likely to be a negative catalyst than positive.

It’s hard to tell with Europe driving all of the attention, but the market is likely not pricing in a legitimate US recession either.  Nor is it pricing in bad future earnings.  According to a marketwatch article from this past week, 73% of S&P 500 companies have reported better than expected earnings thus far this season.

The market likely shouldn’t be pricing in much worse than expected future earnings.  And that’s the point – it isn’t.  Therefore, this is more likely to be a negative catalyst than a positive one.

In the short-term, the trend is higher and this could continue.  However, for the reasons above, I’m bearish in the 1-3 year term right now.  Changes in the above facts could certainly change this at any time.  Moreover, it’s important to address the factors that could make me wrong.  I will do so this week.

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