The world’s problems disappeared, magically and overnight. Last week we saw three major rallies. The first was in the S&P 500; the second in the Volatility Indicator (VIX), and the third was in the Euro. It was the latter that ignited the former.
Right now the Euro is displaying a very strong correlation to the US markets, the VIX and also gold. The Euro tacked on 4% versus the dollar last week, enough to send the markets into a feeding frenzy. The Dow and S&P moved up more than 5%, quite a large move in any market.
For the first time though, the Euro showed that it can influence the price of gold as well. Normally, the price of gold would have shot higher on a dollar decline. Not this time. As the Euro rose, the price of gold fell.
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This is all quite confusing to the market in general. Nothing seems to be well correlated at all anymore. So, the conclusion reached by investors? Buy stocks.
There is an argument out there for buying stocks. I mentioned it a couple of weeks ago: the wall of worry. Right now bearish sentiment is outpacing bullish sentiment by a margin of almost 2 to 1. That usually results in a bounce in stocks, as the market is also usually oversold when that indicator reaches the 2 to 1 ratio.
Stocks are also historically cheap on a forward price earnings multiple. Based on current earnings projections for the 500 companies that make up the S&P 500, stocks are trading at around 12 times next years earnings. That is historically cheap…unless you are in a true bear market. In a real bear market, that price/earning ratio can fall as low as 5 or 6.
So, if the bull case is to be believed, then stocks could rise another 20% to get the P/E back up to 15, the historical norm. If the bear case in place, then stocks could fall up to 50%. Hmmm, which way are you betting?
The Bull Case…Stinks
The bull case hinges on three factors. The first is sentiment. Overly negative sentiment usually precedes a rally in stocks. The question is whether this is a rally in a bull market or a bear market. Second, the bull case is built on stronger than expected growth at home and in emerging markets. China, India, Brazil are all growing at a strong clip. But, are they strong enough to pick up the slack? Finally, low interest rates are a catalyst for growth. Cheap money makes it easier to take risks.
Let’s look at the negative sentiment. Why is it negative? In a bull market, the key driver for stocks is momentum in perceived growth and earnings. Fundamentally speaking, companies are earning more, but on lower growth in revenue. Last week retailers reported another mixed bag with lack of clarity the only thing they could agree on. Sentiment is negative today because there are real issues in the economy: unemployment continued falling home prices, and increasing taxes are three bull market killers.
How about the emerging markets? Yes, they are growing. But, can they pick up the slack? Well, China is huge no doubt about that, but they are also trying to slow growth to prevent excessive speculation. They have reason to.
The growth they are afraid of is growth in inventories – if the rest of the world isn’t ready to buy, then economic growth will slow hard. The growth in China is partly fueled by internal growth, speculation on real estate and a strong export sector. The export sector is still the strongest leg. But… If the US and Europe are forecasting slower growth, China will suffer too.
The Shanghai Exchange was the poorest performer over the past six months…not exactly bullish sentiment. India and Brazil are showing better prospects, but their economies are dwarfed by the likes of China, Europe and the US. So, while positive, they are not major players that can impact global growth – heck even Norway has more cash on hand than either India or Brazil.
Finally, lower interest rates in the US. They are low. Mortgage rates are at their lowest levels in a long time. But, are these low rates spurring growth or are they enabling Americans to de-risk. The answer is the latter. De-risking is the theme right now. Getting rid of debt, refinancing is booming. These are not the engines of growth. Rates are low because they have to be in order to avoid an utter economic collapse. Increasing interest rates are a GOOD sign as they reflect increased economic growth. LOW interest rates for such a prolonged period of time are the opposite. They spell lack of growth and lack of demand. Look no further than Japan, which has involuntarily embraced a zero interest rate policy for decades and are continuing to suffer low growth.
The Bear Case…Wins!
It’s really scary how easy it is to make the bear case. Maybe that is the only salvation in the picture. As I mentioned before, pessimism usually breeds a new bull market…not always.
The bear case revolves around the inability of the US to take the medicine prescribed by the free markets.
Excess housing inventory…hide it on the banks books by not releasing foreclosed homes on the market or by not foreclosing homes in fear that it would only increase their bad debt exposure.
Unemployment…the stimulus packages have failed and employment growth is non-existent. The welfare state continues and it is government largesse that is fueling whatever growth there is.
Debt…it’s a ticking time bomb and it continues to expand to levels that will soon be un-repayable with massive devaluation of the US dollar and debt denominated in those dollars.
Taxes… are about to increase. Municipalities are facing insolvency thanks to low tax revenue from a devaluing housing stock.
Business is seeing an increase in commercial vacancy rates, cloudy consumer demand and higher costs thanks to government-imposed taxes such as Healthcare.
The bear case my friends, makes all the sense in the world. But therein lies the rub. As the economist Keynes once said:
“The market can stay irrational longer than you can stay solvent.”
Funny how that quote is attributed to the economist whose writings on stimulating economic growth out of a recession are the exact same ones that are being put in practice today. Time will tell whether we will enjoy Keynes bounty or his folly.
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Best regards,
Kevin Raymond
