Fundstrat co-founder Thomas Lee expects the market to end the year lower. Though he thinks this drawdown is part of a larger bull market that won’t end for a few more years. Lee’s short-term concerns for the market revolve around nominal GDP which he expects to be at about 3% next year. Lee recently cut his earnings estimate for the S&P for this year. Following is a transcript of the video.
Henry Blodget: Our next guest called the bottom in 2009 just a month early, then was all the way up on board and has recently turned cautious. Tom Lee is the head of research at Fundstrat Global Advisors. Tom, you recently cut your estimates on the S&P 500 and you’re saying the market will be lower, dare I say it, by the end of the year?
Thomas Lee: Yes, that’s right. It’s an uncomfortable call to be honest, because one, our clients don’t like the idea that — look, a market being so strong actually has downside risk and of course, it’s, you know, it’s tough for people to find ideas in that environment.
Blodget: But you do point out some sectors of the market you think will continue to do well like the FANG stocks that have done so well thus far.
Lee: Yeah, that’s right. I think that investors really need to scrutinize where true earnings power is coming from in this market. And it’s coming from FANG. These are secular growths, growing 25% top-line and 30% earnings. But the rest of the growth is really being driven by resource sectors, financials, and even telecom turning next year. So it’s not your traditional stocks that are growing at 10%. I mean the markets really got a medium growth rate of like 8 or 9 and then it’s these other sectors that are really producing a double-digit gain.
Blodget: And so what is it that causes you to be cautious on the market overall?
Lee: There’s a couple of things: One, you know, so we think that they’re still has to be a linkage between underlying fundamental growth and market valuation. So two ways to look at it. One is median PE. Median PE is now close to 19 times forward. It’s the 91st percentile median PE over the last 30 years. The only time it’s actually been higher was ’98 to ’99. So I think it’s really stretching valuations unless earnings really pick up.
The second is looking at market cap to GDP. And it’s currently — if you strip out the global market cap, right, profits earned overseas — that ratio is around 89%. Outside of the 99 period, you have to go all the way back to 1929 to find the market trading at a higher market cap to GDP ratio.
Blodget: And as in the 1990s, folk seem to have a lot of very good reasons why the market is where it is and often point out, ‘Hey, if we are akin to 1998, we still got all of that 1999 upside.’ How do you time an exit or a lightening when you are looking at valuation?
Lee: Well, I think it’s — I mean, that’s the tension, right, in our view? Because I don’t necessarily think we have a business cycle turn coming and a recession. But we have a nominal GDP problem. If real growth is only 2 and inflation expectations are falling, that means nominal growth is only going to be 3. Earnings growth is really essentially going to be 3%, and I think when you see estimates out there that look for 12% growth next year, it’s grounded on this view that inflation picks up and real growth picks up and if neither takes place, then earnings are too high, which is the reason we think estimates are actually way too high out there.
Blodget: But you don’t see a recession? You think this is just a pause for a while.
Lee: Yeah, I think that if I was to stage it like say, it’s like the hands of a clock, I think right now it looks like it’s 9 o’clock. So we still have several years of expansion ahead. But the yield curve spread to 10:30 is telling us the economy is a lot more advanced. So you know, maybe closer to 10 or 11.
Blodget: And what do you, when you look at the Trump Administration — President Trump was elected and lots of excitement about tax cuts and regulatory rollbacks and so forth. A lot of that has not happened on the time frame that people thought. As you look forward, are you expecting to see some improvement there?
Lee: You know, when we first heard the talk about stimulus, tax reform and Obamacare repeal, I think, from a consensus perspective, it’s unrealistic what people are expecting. And I think now we are starting to see some sobering of expectations, right? So tax rates, maybe at 28%, which is essentially no change. I think the only place to be really optimistic for business is deregulation. Because over the last 8 years, we’ve probably seen one of the greatest increases in regulatory burdens for corporates. Just three sectors, banks, energy and the industrial sector, have almost $US85 billion a year of incremental cost associated with major regulations.
Blodget: And so given the mix of what you’re seeing, the stock market. Are there other assets that you are recommending? What are you telling your clients to do: park and wait it out or just diversify into other sectors?
Lee: Well, it’s a, you know, in some ways, I still think high-yield is a great way to get exposure because you get 80% return of the stock market with half the volatility. So I think in some ways, if this cycle has proven anything, high-yield is actually a really good business. And you know when you look within high-yield, you know, you can always isolate sector so you don’t have to have high yield with energy. You can buy high-yield without energy or you can buy the Triple C part of high yield and pick up close to 78 per cent yield. So I think high yields are great asset class. I think it’s really proven itself in this cycle. And I think what’s interesting is I still think there’s room for alternative currencies in people’s portfolios, whether it’s gold or crypto-currencies. Yeah, I think it’s actually security so that true currency trades but they’re anti-currency trades.
Blodget: And then lastly on the stock market. In one of your recent notes, you talked about how secular bull markets usually last more than 20 years. This one is only 8 years old. Are we headed for a correction on that in a secular bull market or are we still in this workout phase from the 1990s?
Lee: So, if we look at these long bull market periods, the secular bull markets, which is multiples expanding, that ’82 to ’99 period included the ’87 crash, which market fell 40%. So I think there is room for a huge drawdown that would reset expectations but it’s — it wouldn’t change the view that maybe we still have higher prices at 2025. I think the problem today is that market growth, the rise in the market has way been ahead of GDP growth.
Blodget: Tom, great to have you. Thank you so much.
Lee: Great to be here.