September 24, 2009
1. Insider Selling: An Oversupply of Paper
Insiders have been quick to recognize that the market is hungry for paper. Thus, they are selling shares, and issuing debt and/or equity at an alarming rate. Investment bankers, who were very recently idle, now have a backlog of paper ready to go to market, which will eventually flood the market and offset the fragile balance of supply and demand.
Why are they doing this? They are cashing out while they can. Nobody understands a business better than its insiders. Irrespective of what the Wall Street “paper pushers” say, if this is the next bull market, insiders would be buying shares, not selling.
2. A Rally Based on Short Covering, Low Volume, and Bankrupt Companies
The rally since the March lows has been relentless and sharp, and one of the primary catalysts for its vicious move up is the combination of low volume with short covering, especially in high beta, low quality stocks. Liquidity is exiting the system, not entering; and for some reason, those who are still trading are infatuated with such names as FNM, FRE, WaMu, AIG and Lehman.
These are not the signs of a healthy system; rather, it is panic buying similar to that of the NASDAQ in 2000 when investors piled into internet stocks based on “page views,” given the absence of revenue as a basis for investing. Even rational investors began to question the old business model of revenues minus expenses equals net income. They did not understand why a solid brick and mortar business would not be as “sexy” of a buy as the profitless internet companies. We all know how that turned out.
3. Bullish Sentiment and Market Psychology
At present date, market consensus is short-term bullish and long-term bearish as a result of the aforementioned buying frenzy. Everyone wants to buy the markets and exit before the bubble pops. Guess what? If you want to participate in this bubble—it's too late. The time to buy the markets was when everyone was bearish, when the WSJ had an article titled “Dow 5000,” and the S&P was at 666. Even if you missed the move from 666 to 800, you could have bought the markets at S&P 800. But with the S&P at 1100, everybody fully invested, and Wall Street shops paper like there is no tomorrow, right now is the time to sell!
Irrespective of factors like momentum and technical indicators, selling is wise because momentum and technical indicators fail to incorporate deteriorating fundamentals in their formula and, therefore, have no way of detecting “market moving” bad news. In an environment where fundamentals deteriorate and equities get more and more overvalued on a daily basis, any taste of bad news can crack the momentum. Being bullish in the “short-term” because of momentum is a flawed rationale, and soon the last piece of research from bullish technicians will become obsolete. The market has become delusional and is living in fantasyland in the same way people were dancing in the Titanic on the eve before it crashed into an iceberg.
4. Short the USD, Long Everything Else
The market is crowded in one trade—short the dollar and long everything else—a dollar carry trade. For example, you short the dollar and buy Macy’s (M) shares, Gold, Silver, the Brazilian Bovespa, Venezuelan bonds, New Zealand Kiwi, Washington Mutual, Goldman Sachs (GS), you buy anything and you do not discriminate. With the positioning in the market so concentrated, we have the potential for a moral hazard—as when the trend reverses, there will be no one on the other side. This is why markets crash!
Correlation is not causality; we can say the same thing by blaming the USD weakness for every market movement. Is everything bad for the buck or is the dollar bad and everything else is good? The short selling inherent in the dollar carry trade puts added pressure on the dollar and reinforces its inverse link with risk appetite. This also implies a substantial rebound in the dollar once stock markets globally sell off, because carry traders will need to unwind their bets by buying back the dollars that they shorted.
5. Deteriorating Fundamentals and Rising Income Dispersion
According to a government report earlier this month, household incomes in the US decreased and more Americans were living in poverty in 2008. The poverty rate climbed to 13.2 percent last year from 12.5 percent in 2007. The number of people living in poverty rose to 39.8 million last year, an increase of 2.6 million from 2007.
Yet the paper pushers on Wall Street continue to accord themselves record businesses and record profits. In the same year that the US reported that 39 million people were living in poverty and a record use of food stamps, Goldman Sachs reported record profits. Now if Goldman Sachs were operating a manufacturing facility that employed thousands, and they invented the cure to the common cold and now was selling a billion vaccines to China, their “record profits” would be justifiable. But, instead Goldman Sachs is “trading away” after being bailed out by the government with taxpayer money, and they get to enrich themselves while the rest of the country impoverishes itself.
This is defined by John Williams of shadowstats.com as a rise in income dispersion. A high level of income dispersion indicates heavier income concentrations in the extremes. Conditions surrounding extremes in income variance usually help to fuel financial-market bubbles, followed by financial panics and economic depressions. The poverty report is enough to clearly depict the economy’s deteriorating fundamentals—we need not mention the state of the country’s commercial real estate business or the slow down in shopping or an infinite other number of things that are deteriorating on the micro front.
6. The Chinese Commodities Bubble
The rapid rise in commodity prices is not because China is growing at a very rapid pace together with its BRIC brothers and other emerging nations—it is quite the opposite. China has inundated its market with excess cash, and this cash is being converted to commodities because they would rather hold physical assets than worthless paper money like the US dollar.
This conversion from dollars to commodities is conveying the message that China is growing. However, China’s business model is as broken as that of the US. They depend on a huge export manufacturing base of gadgets that are to be sold to the US consumers using borrowed funds. For China to grow internally and build its own consumption, it will take years/decades not months. So this theory that the Chinese will get the world out of a recession because they are buying commodities is a fallacy, nothing more than that.
As John Horseman points out, the China story is just how large many of her basic industries such as steel and cement have become and just how much excess capacity now exists. To put this into perspective; China has capacity to produce some 660 million tons of steel per annum, more than the EU, Japan, the US and Russia combined with another 60 million tons of capacity currently under construction. She currently produces around 500 million tons, suggesting that idle capacity exists which is equivalent to the total of Korean and Japanese output. China's consumption of steel is already equal on a per capita basis to the EU and higher than the US, raising the question as to just how much higher steel consumption can go. Despite China's efforts to stimulate, Chinese steel companies are racking up large losses. Much of this surplus represents a severe limit on the prospects for growth. The bottom line here is whether the Chinese government’s growth story while global trade is shrinking can prevent the financial markets from derailing.
7. Trade Protectionism, Socialist Tones, and Government Intervention
The objective of Reaganomics during the 1980’s was to:
a) reduce the growth of government spending,
b) reduce income and capital gains marginal tax rates,
c) reduce government regulation of the economy, and
d) control the money supply to reduce inflation.
The objective of Obamanomics is exactly the opposite. In addition, the rhetoric between nations cannot be worse. All we need to figure this one out is to read the newspaper—will imposing tariffs on Chinese tires be positive for global growth and trade? No further discussion is necessary.
8. Money Supply and Credit Contraction
The money supply and credit is contracting at an alarming rate. No matter how you spin this, it can only lead to bad news for the economy. If credit continues to contract as a result of banks reducing their lending and/or consumers not borrowing, it can reach levels that can disrupt normal day-to-day commerce. Once this happens, the economy hits a brick wall and collapses—i.e. what happened with Lehman Brothers a year ago.
The situation is only getting worse as credit continues to deteriorate. The worse is ahead of us not behind us, and if no imminent action is taken by the government to accelerate lending, the country can find itself in the Great Depression—Part II. If the necessary action indeed is taken, it will not be positive for equity markets, which are operating under the assumption that the worst of the systemic and financial crisis is behind us and that banks can operate without a hand from the government. Again, Lehman is history and the future is rosy and pretty.
9. Market Complacency
Expanding on the issue addressed above, the market seems to be very complacent. The VIX and all the “fear” indices are at 12-month lows and the market is no longer paying for “protection.” Basically, the market is assuming the system is “risk free” as it was during 2003-2007 when maximum risk taking was rewarded and encouraged. Black swan events were impossible back then.
What happened to all the troubles brewing in Europe? What happened to Latvia’s currency crisis or the Swedish Banks? Are Hungary and Poland ok? Has the Austrian Banks’ exposure to Eastern Europe disappeared? Is Spain back on its feet? Is the UK solvent again? Are Irish banks lending like there is no tomorrow? How about Germany’s manufacturing base—is it solid with a EUR at 1.48 and the US consumer missing-in-action? Is Deutsche Bank’s $3 trillion balance sheet made up of only physical Gold? Are German banks profitable and healthy again? I guess somebody waved a magic wand and fixed all Europe’s problems overnight!
Brian Bloom, Market Oracle
May 3, 2009
In the past few weeks the tone of this analyst’s articles has turned markedly more bearish. Regardless of the strong rally in recent weeks, the “bird’s eye” evidence seems irrefutable: Within the foreseeable future there is a high probability that the Primary Bear Market will resume in earnest.
Unless there is a structural change in the behavior of the world’s political and financial authorities, a stock market crash in the USA seems to be on the cards, and this will likely cascade through other markets.
By contrast, a redirection of the buckshot approach of our political and financial leaders towards a rifle approach might be able to prevent such an outcome. There is an immediately available (and practical) alternative route that will be economically stimulative in a way that will almost certainly lead to compounding growth in employment opportunities.
Using 1933 as a base starting point, if we look at any of the long term rising trend lines drawn on any of the Red (Overvalue), Blue (Fair Value), or Green (Undervalue) lines, we see that all three “theoretical” levels currently sit far below these trend lines. True, the absolute price of the S&P has not yet adjusted but, based on underlying values, the markets are anticipating the possibility of a “Super” Primary sell signal.
There will be some who will argue that the rationale behind this theoretically overvalued situation is that earnings are expected to bounce back. They will argue that if this happens, then the black line need never penetrate below its 75-year trend line.
The table below is reproduced from DecisionPoint.com. It reflects the most recently reported and projected twelve-month trailing (TMT) earnings, quarterly earnings, and price/earnings ratios (P/Es) according to Standard and Poors.
Now, we can paint any rose colored picture we like; and we can argue any brilliantly convoluted logic we can conceive, but no picture and no argument will negate this stark evidence. If Standard and Poor’s forecast of GAAP profits over the next 3 quarters turns out to be correct, then P/E ratios at the end of calendar 2009 will be around 30X. i.e. By implication, in nine months time, if the P/E ratio falls to reflect historically overpriced levels of 20X, then the $SPX will fall to around 20 X 28.51 = 570.2.
OK. Let’s look at where 570.2 will be on the $SPX. The following is the long term line chart dating back to 1924 – also courtesy Decisionpoint.com
Hmm? 570.2 looks like it will be smack on the rising trend line.
OK. But why should the historically overvalued P/E ratio of 20X be the target? Why not 15X – which represents the 75-year “fair” value level?
Well, supposedly at that time (end December 2009), the markets will be looking a full year into the future. So, in order for a future P/E ratio of 15X to be justified, the underlying GAAP earnings for calendar 2010 will need to rise by a minimum 33% to 570.2/15 = $38, which is roughly back to where they were in third quarter 2008. (Note: $23.25 loss for the quarter ended December 2008 added back to the 12 months trailing earnings of $14.88 to December 2008 equals implied $38.03 for the trailing 12 months earnings to September 2008). It is emphasized that September 2008 was before the market crashed – see Dow Jones Industrial Index chart below, courtesy Bigcharts.com.
With all the above in mind, a maximum of $38 per share average, GAAP adjusted, 12 months trailing earnings for the S&P 500 to December 2010 is a tall order, but is conceivably possible – provided the economy bottoms at around this level and revenues start to rise again.
Unfortunately, the days of “real” compound growth in excess of population growth seem to be numbered – given that unemployment is still rising and that 70% of the US economy is driven by consumer spending; and given, also, that most consumers are saddled with debt in the face of house prices which have fallen significantly. For example, median house prices in Phoenix (the largest fall in the country) have fallen by 51% from their peak (see: http://www.bizjournals.com/phoenix/stories/2009/04/27/daily16.html?ana=from_rss).
It follows that by no stretch of the imagination can any future P/E ratio in excess of 15X be objectively justified based on currently known facts.
Interim Conclusion #1
Inflation aside, and given the highly unlikely outcome that the targeted 12 months trailing GAAP earnings which underlie the S&P 500 index will rise to a level – by the end of 2010 – that is higher than they were in September 2008 (before the crash), there is no reasonable argument that can defend a rise in the level of the $SPX from here. This level of earnings is already being fully discounted almost two years into the future. Therefore:
A “best case” scenario seems to be: A sideways movement in the $SPX for some years until the price hits the rising trend line.
A “base case” scenario is: Another substantial fall in the equity indices, until the price bounces off the rising trend line at around 570 (36% fall from current level).
A “worst case” scenario is: There is a risk that the indices will fall below the 75-year rising trend line if the politicians stubbornly continue to focus on the symptoms rather than on addressing the core problem. The continuation of such an unwise course of action will very likely cause a market collapse of such dimensions that it would presage a destruction of the momentum of world economic growth.
Where to now?
Cold and unemotional reasoning leads to the conclusion that the old thought paradigms relating to industry, finance and commerce are no longer appropriate. The chart below – courtesy DecisionPoint.com – shows that interest rates are under upward pressure.
It should be remembered that wages lag inflation. If the yields are rising because of imminent inflation, then the US consumer will find himself between a rock and a hard place:
- The rock: Saddled with debt and facing the reality of a contraction in home equity, the upward pressure on interest rates will place downward pressure on the ability of those consumers who remain employed to service their mortgages. Additionally, upside pressure on prices (price inflation) will place further downward pressure on the average consumer’s ability to make ends meet.
- The hard place: Because wages lag inflation, consumer income across the board will not keep pace with inflation.
The most logical conclusions – if the politicians continue down the path of throwing money indiscriminately at the economic symptoms – are:
- Velocity of money will continue to spiral downwards as volumes of transactions contract.
- Bank balance sheets will be further impaired as fewer consumers are able to honor their debt obligations.
If the politicians and financial authorities continue along the path of “buckshot” attempts to stimulate the economy without focusing on the concept that investment needs to be in industries which can create a compounding growth in employment opportunities, the end result will be a credit crunch as banks find it increasingly difficult to find credit worthy borrowers. A credit crunch, should it manifest, will inevitably lead to a further collapse of equity prices. On the day when the market finally focuses on the likely consequences of rising interest rates, that day is when the equity market prices will recommence their Primary Bear Trend in earnest.
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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