It’s the Fundamentals (Stupid)

We aren’t saying that the market upheaval of last week was caused by fundamentals. It’s hard ex post facto to attribute an unwinding to any one event, or set of events, and in this case, there are many possible culprits. If we had to attribute it to any simple set of causes, it would be a tightening of liquidity in key markets (per below), and the spike up in the VIX, meaning there was a sudden increase in volatility expectations (that is, for whatever reason, a bunch of investors woke up and realized the complacency was way overdone).

On the liquidity front, Larry McDonald tells us in “About Recent Financial Turbulence” at Seeking Alpha that

One trigger for the recent turbulence in stock markets was a stepping up of efforts to withdraw liquidity from the world economy. In the weeks and days leading up to the breakdown:

One trigger for the recent turbulence in stock markets was a stepping up of efforts to withdraw liquidity from the world economy. In the weeks and days leading up to the breakdown:

* The People’s Bank of China raised reserve ratios on financial institutions to 10%, the fifth hike since mid-2006
* The Reserve Bank of India raised reserve ratios by 0.5% to 6.0%, the second since December
* The Bank of Japan raised its central rate from 0.25% to 0.50%.

China and India are expected to continue tightening in response to inflationary pressures. Indeed, the China Economic Review says analysts expect reserve ratios in China to go as high as 11.5% in 2007. And analysts expect more hikes in India given domestic inflation of 6.5% and forecasted GDP growth of 9.2% (highest rate in 18 years).

Now (as I have said) what is going to keep markets unsettled for longer than the optimists hope are the weak fundamentals. Normally, markets can brush off middling and mixed fundamentals because, on average, economies show more growth months than low or non-growth months by a considerable margin. So blindly betting on the bull case is pretty safe.

But what happens from time to time is the market gets ahead of itself, valuation wise. That can lead to short-term downturns and profit taking. Again, the smart bulls wait until the correction seems to be losing steam and take advantage of the buying opportunity.

When you have overvaluation and generally lousy fundamentals, however, the dynamic is different. Valuations need to settle down to a much lower lever before the market can begin a sustained rise. And the fundamentals look pretty poor. Barry Ritholtz, in another Seeking Alpha piece, eviscerates a cheery story by James Pethokoukis, “Don’t Use the Market to Predict a Recession,” in US News & World Report by taking apart each of the supposedly encouraging indicators that Pethokoukis cites:

What are the hopeful pleas of the soft landing proponents? Consider this short list, and our counters:

1) Corporate America remains healthy

The good news is that corporate balance sheets are the best they have been in years. The bad news is that matters a lot less than you would think. The lift under major corporate strength has been earnings — which have been decelerating for quite some time now, and are likely to get worse, not better in the near future.

The strength there is somewhat deceptive. A vastly disproportionate amount of S&P500 earnings have come from Oil & Material companies. As the economy slows, that will slip. We also see a lot of M&A/Private Equity driving the Financial sector. A shift in Psychology is underway, and that is likely to look different if this selloff accelerates. Third, a lot of financial engineering has occurred. Share buybacks are responsible for about a third of earnings gains. Bottom line: S&P500 earnings remain a lot more vulnerable than most people realize.

Then there’s the profits at a cyclical peak: Earnings cannot grow faster than GDP + inflation indefinitely. As we have pointed out before, this profit cycle has been driven by cheap labor, cheap money, and tax breaks -not organic demand.

2) The GDP report wasn’t all bad

That’s true: 2.2% isn’t zero.

However, it is not 3.5%, either. And it’s trending lower. Even more importantly, it does not reflect the thesis that helped the markets power higher from December through February: That growth was reaccelerating, that the soft patch was behind us, that a soft landing might not even be necessary due to the robust economic environment.

That turned out to be dead wrong: Housing is already in a recession, as is Autos and most Manufacturing that is not cheap dollar export dependent. Durable goods have been weakening along with Housing, and Business Investment – which the Bulls have been forecasting for 3 years – is near a 3 year low, with more weakness likely on tap.

The “contained sub-prime debacle” and the “not dependent on housing consumer” turned out to be Fairy Tales – like Goldilocks herself.

3) Jobs remain key

It’s stunning that this keeps getting trotted out, but let me repeat it in CAPS for those who have have somehow missed it: THIS HAS BEEN THE WORST JOBS RECOVERY IN POST WAR HISTORY.

We’ve mentioned this repeatedly over the past 3 years, most recently here and here.

4) Federal taxes keep pouring in

Temporarily true, primarily due to a number of factors and one time events.

But if you want to get closer to where “the rubber meets the road,” have a look at State and Local tax receipts. They are in near crisis mode in many places, as Income gains, and Hiring and Consumer Spending are all off of where they should be at this point in the cycle. Productivity gains are clearly a double edged sword this cycle also.

For The Liscio Report’s prior take on State Tax reciepts plummeting, see #3 here.

Note we agree with Barry on corporate earnings, but for different reasons. Earnings quality has been terrible, independent of the trend. Much more accounting gimmickry, even with Sarbox, and a good deal a result of either unsustainable or damaging cost cutting (ie, it’s really disinvestment, starving future quarters to look good now). It looks like companies are starting to have to pay the piper.

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