I’ve refrained from discussing the stock market for quite some time, in part because this is not an investment website and in part because I find the netherworld of credit more interesting. But a big reason of late is that the stock market has become so utterly unhinged from fundamentals that anyone opining on it, other than momentum trades and technicians with particularly good crystal balls, is likely to look silly.
We seem to be in a toxic replay of what I called the Tinkerbell market in 2007 and 2008: if the officialdom can get enough people to applaud, the economy will live. They weren’t too successful back then, but the crisis has appeared to have upped the game of the Powers That Be in talking up the price of financial instruments. And having the Fed at ready to provide boatloads of liquidity should anything go awry appears to have put much of the world in “don’t fight the Fed” mode.
Market action is looking a tad manic, yet the dot-com mania proved that unwarranted optimism can persist far longer than cooler heads deem possible. Hedge fund leverage, for instance, is allegedly back to pre-crisis highs. And various market commentators are pointing to worrisome echoes of dot-com type preferences, where stocks amenable to fantasy, or what Bill Fleckenstein calls “imagination” are preferable to ones with clearly better prospects. From his commentary last Friday:
Yesterday, I was discussing how speculative the market had become and I believe the reaction to the results of those two companies [Intel and JP Morgan] illuminates that further.
Chipping Away at Intel Starting with Intel, it beat estimates and said it would increase capital expenditures, which sent pulses racing in semiconductor equipment stocks, while Intel’s stock (after being higher last night) was sold, losing 1%. The reason Intel’s results were not good enough, even though it trades at a modest ten times earnings, is because in this speculative atmosphere, people want motion, just as they did in the last stock bubble. They will chase any manner of Chinese Internet, tablet, or cloud computing stock, as well as poorly positioned companies like Micron or Research In Motion, but they don’t want to buy a company like Intel, let alone Microsoft…
As for JPM, it is a variation of the same theme, because financials have an imagination component in the same way Internet stocks used to. You can believe anything you want, because the numbers are no good. Thus, JPM’s results were lapped up and that stock gained 1.5% initially, before selling off a bit later in the day.
When you have a speculation-driven, money-printing frenzy, there is no telling what sort of ideas will be latched onto. If you need a reminder, go back and read the newspapers from 1998 through 2000…
I also don’t mean to imply that I know when this frenzy will end, because I don’t. If history is any guide, it is liable to get far crazier before it exhausts itself. I certainly hope that’s not the case. I really thought after all we’ve been through, especially in 2008 and 2009, we would not have another out-of-control stock market for at least a generation.
David Rosenberg, who has had the misfortune to make astute calls on the fundamentals but miss how liquidity-addled investors would react, also takes up the imagination theme in his note of last Friday (hat tip reader SF):
CREATING AN ILLUSION OF PROSPERITY
If the name of the game was to revive investor “animal spirits”, it has worked wonders so far
How can it be all bad? After all, the Fed’s “Beige Book” did highlight that all 12 districts have reported an improvement in the pace of economic activity. In the previous Beige Book, which covered the month of October and early November, there were 10 who reported the same…
No doubt a lot has happened to generate the newly-found optimism…In August, we had Ben Bernanke verbally hinting that more central bank balance sheet expansion and liquidity were on its way. If the name of the game was to revive investor “animal spirits”, it has worked wonders so far even if Treasury yields are up around 100 basis points from the lows. I’m sure Ben would gladly accept 100bps on the 10-year note for a 10% runup in the S&P 500..
And let’s face it. The incoming economic data have not looked that bad at all…
Nobody should be reading this and jumping to the conclusion that my fundamental views have changed over the contours of this post-bubble-bust economic recovery. The economy remains on government-assisted life support, and the government has been very successful in creating the illusion of economic prosperity. It is doing this to buy time and help preserve social stability as the adjustment towards housing deflation, consumer deleveraging, and chronic unemployment takes its toll on the growth rate in organic final demand.
And in case you think there is good reason to believe the recovery is on, there is plenty of contradictory information. Federal fiscal stimulus is not all that large and will be offset, and perhaps overwhelmed, by state and local government belt-tightening. Consumer spending plunged in early January. Energy and food price hikes have the potential to put any recovery into reverse, and a super La Niña would intensify both pressures. And that’s before we get to the usual worries: the drag of an unresolved foreclosure mess on housing prices, the odds of Euroworries producing a full bore crisis, and rising inflation in China pressuring the officialdom to dampen growth, which skeptics believe will burst its bubble, or let prices rise, which runs the risk of increasing social unrest.
Even former believers are getting a tad edgy. For instance, Morgan Stanley warned at the end of last week that corporate profit increases were due to become a thing of the past. From the summary of its note “The Coming Flattening in US Profit Margins”:
Earnings deceleration despite economic acceleration: We think earnings growth will slow significantly despite a moderate US economic acceleration in 2011. The culprit: A coming flattening in profit margins due to slowing output growth abroad, fading operating leverage, and an end to the decline in interest expense.
Four reasons margins have soared: 1) Strong growth abroad, especially in the booming EM economies, that lifted results of US affiliates abroad; 2) capital discipline that enabled companies to exploit their operating leverage and boost ROICs; 3) strong control over balance sheets that has kept a taut rein on interest expense; and 4) hiring discipline that reduced total compensation, especially the fixed costs of healthcare benefits.
Four sources of flatter margins in 2011: 1) Growth in overseas output is likely to slow somewhat; 2) operating leverage will fade as fixed costs like depreciation start to catch up to sales; 3) declines in interest expense will end; and 4) for some companies, rising commodity prices will foster margin compression.
But for now, the answer is obvious, which is play the imagination theme to the hilt. Thus a Financial Times comment gave very bad advice to Facebook’s Mark Zuckerberg, telling him to give up his hoodie and dress like a proper CEO. Nonsense. The youthful look is as much part of his brand as Steve Job’s signature black T-shirts, and key to the fantasy that social media as eternally youthful, and therefore with continuing growth prospects.
So enjoy the ride while it lasts. As with the credit mania of 2007, investors will assume they can get through the exits when the party stops. And some did, but many were trampled in the ensuing panic.