February 6, 2014

Why Wall St.’s Bullish Stock Stance Is Wrong

Portfolio manager Ron Surz reverse-engineers firms’ forecasts, and offers what he regards as more realistic assumptions

Wall Street firms across the board are expecting another year of stock market gains, and California-based quant Ron Surz thinks he knows why:

The cognitive bias known as “anchoring” has set their market expectations around a P/E of 20, and from there they are plugging in their earnings growth expectations to project returns ranging from 13.61% (Weeden & Co.) or 12.26% (JP Morgan) down to .09% (Deutsche Bank) and 2.79% (HSBC).

Of 15 major brokerage firm forecasts, 14 are in positive territory with only Stifel Nicolaus predicting a market decline of 5.32%.

Common to these upbeat forecasts are assumptions that the San Clemente, Calif.-based portfolio manager has reverse-engineered using a matrix developed in the late ’90s by Rob Arnott and Peter Bernstein and published in the Financial Analysts Journal in 2002.

Anyone can use this formula to come up with his own forecast, Surz told ThinkAdvisor in a phone interview, adding that Arnott and Bernstein used it in the late ’90s to accurately predict that the coming decade would be an unpleasant one for stocks.

The formula is quite simple: return is equal to dividend yield plus some estimate of earnings growth times P/E expansion or contraction.

(Bill Gross of PIMCO devoted his February investment outlook released Wednesday to his expectation of P/E contraction, which is why he said that stocks would “lose some luster.")

The upbeat Wall Street forecasts imply a static P/E of 20, which drove last year’s 30% market rise, along with varying earnings growth assumptions. But Surz, who manages target-date funds for Hand Benefit & Trust of Houston, thinks this is far too optimistic.

“The normal situation is earnings growth of 6% and a P/E of around 15. If you go into that matrix…what that implies is a return of -16%,” Surz says.

Surz thinks P/E ratios, already down to 18, are headed down to their more normal range for at least one key reason: inflation, which has been anything but normal. Citing a scatter plot produced by Crestmont Research, Surz says that periods of either high or low inflation lead to contractions in P/E, with high P/Es grouping around inflation rates between zero and 5%.

The portfolio manager says that today’s debate centers around whether there will be inflation or deflation in 2014, with few arguing for constant single-digit inflation, thus implying P/E contraction.

Surz is in the high-inflation camp, citing the as-yet unknown consequences of quantitative easing. Specifically, he cites the trillions of dollars the Fed has pumped into the economy, which has not translated into inflation only because “there’s no velocity” in today’s still-depressed environment.

“So when they go try to suck that out, will they be able to effectively do that so that it doesn’t get into the economy? Because if it does, we’ll get serious inflation.

“Banks can lend $10 on $1 in reserves. So on $3 trillion they can lend $30 trillion … Those numbers are so big I just can’t get my head around it."

But whether your assumption is insidious inflation or dangerous deflation, Surz says that market history affirms that either way, you should expect stock prices to be headed downward.

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