The Reverse Tepper Argument
David Tepper is the founder and manager of the multibillion dollar hedge fund Appaloosa Management. He is also well-known for an appearance made in the financial media back in September of 2010. In that segment Tepper made the case to investors that stocks would go higher regardless of whether or not the then-nascent economic recovery was for real.
During that TV segment, he outlined what would be called the Tepper Argument: The premise that the economy would recover, causing stock values to rise; or that the economic recovery would fail, causing the Fed to massively pump up stock prices by expanding its QE program. To learn how the Fed uses QE to boost the market read last week’s commentary.
Mr. Tepper deserves credit for recognizing, in the wake of the financial crises, that stock prices would go up no matter what economic condition prevailed — I also advised investors to go long equities in early 2009, after advising them to head into cash during the summer of 2008.
However, it is imperative for investors to realize that the exact reverse of the Tepper Argument is now in play when analyzing the market today.
The Tepper argument made a great deal of sense in the fall of 2010 for several reasons. First off, the Fed was an avowed money printer and openly proclaimed its ready and willingness to aggressively expand its balance sheet to combat deflation. At that time, the Fed held “only” $2.3 trillion worth of assets. But today, the Fed’s balance sheet has swelled to $4.3 trillion. The central bank has now become fearful about the amount, duration, and quality of the assets it holds and superfluity of Fed credit held by financial institutions.
Secondly, the S&P 500 was trading at 1,109 when the Tepper argument was first made. Today, the benchmark index is at 1,878-a 70% increase! In fact, the S&P is up 180% since the March 2009 low. The market has gone from undervalued to bubble territory in just a few years. For example, the Russell 2000 had a PE ratio of 34 last April. Today, the PE ratio has soared to over 100.
Most importantly, and in sharp contrast to several years past, the Fed is now committed to ending QE and the cessation of its balance sheet expansion. Whereas in 2010, Mr. Bernanke was committed to exorbitant money printing to obtain his inflation quest, the Yellen Fed has made it clear that it will primarily utilize Fed Funds rate targeting to meet GDP and inflation goals, instead of purchasing long-term Treasuries.
Therefore, investors now face an entirely new paradigm that is diametrically opposed to the original Tepper argument.
Scenario number one: Economic growth and inflation reach the Fed’s target levels and interest rates rise sharply on the long end of the yield curve to reflect the increase in nominal GDP. This will cause a selloff in the major averages, as the 10-Year Note jumps to 5% from its current level of 2.70%. Surging interest rates–the result of inflation and the end of QE rate suppression–will provide competition for stocks for the first time in seven years and a correction of around 10-20% occurs.
Scenario number two: The economy once again fails to make a meaningful recovery, and the overvalued market crumbles under the weight of anemic revenue and earnings growth that is woefully insufficient to support the current lofty PE ratios. Without the aid of massive money printing from the Fed, or a surge in GDP growth, a significant correction north of 20% is highly probably. Keep in mind revenue and earnings growth are less than half the historical average, and need to rapidly accelerate in order to justify the current level of the market.
For stocks prices to rise from this point, the economy must grow rapidly without causing interest rates to rise. This is a virtually impossible scenario, especially since the Fed is removing its bid for Treasuries. So, either the economy doesn’t improve and stocks fall (because the Fed won’t reverse course and increase QE on a dime), or the economy improves and the interest rates spike spooks the market. Either way, the market goes down in the short term.
I believe a bear market will ensue from weakening economic growth combined with the attenuation of Fed asset purchases. Further proof of our structurally-anemic economy came when the BEA released data on April 30th that showed the economy grew at an annual growth rate of just 0.1 percent during Q1.
Our central bank is now buying $45 billion per month of MBS and Treasuries. Down from $85 billion at the start of this year. That number will be near zero in just a few months. Real estate and stock prices have already stopped rising and economic growth has almost completely stalled since the start of 2014. The bear market in equities and stubbornly-high unemployment rates should bring the Fed back into the debt monetization business shortly after the market crashes. This significant selloff should prove to be a crucial buying opportunity in which investors need to be preparing now to take full advantage of.
So where does this leave investors? Here’s a brief synopsis.
- The S&P 500, Dow and NASDAQ are all expensive when measured by historical norms.
- The U.S. economy has stopped growing, even as measured by our own government.
- China’s economy is slowing, as the PBOC tries to restrain the credit growth that created a humongous bubble in fixed assets.
- Emerging market economies have significantly raised interest rates to defend against plunging currencies, which is dramatically slowing their growth.
- Japan is a bankrupt nation that is destroying its currency in a quest to create inflation, which is wiping out its middle class.
- And the Fed continues to reduce its support for the asset bubbles it has tried to desperately to re-inflate for the last six years.
If this is an environment in which investors want to jump into stocks, they can do so without me. Just as was the case in 2008, a little bit of patience should prove to be an incredibly smart decision, and it should also save investors from a lot of pain.