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 November 2007 Something's Got to Give
On the one hand, interest rates are being pressured in both the U.S. and Europe. The Fed's decision to cut the Federal Funds rate in September and then again in October has left the dollar weakened and has sent commodity prices which are typically priced in dollars, soaring. When coupled with a declining real estate market, consumer spending could be the next to turn south. All of this would generally spell problems for the overall economy. It would normally also weigh on stocks. A slowing economy usually leads to declining earnings and falling stock prices. But the exact opposite happened in September and October. Although stocks had a few sharply down days, they quickly recovered to set new highs on almost all markets except the Nasdaq. If interest rates, commodity prices, and the economy are sending warning signals, investors certainly aren't receiving them.
Sentiment has also remained relatively buoyant. As earnings growth falls, the dollar declines, and inflation lurks, investors have adopted the Alfred E. Neuman approach of "What? Me worry?" About the only thing they appear concerned about is not exploiting the most recent dip as a buying opportunity. It's not supposed to be this way. Modern Portfolio Theory expects markets as a whole -- if not individual investors -- to be rational agents, building all available information into current prices. Why would rational investors be buyers when so many indicators are aiming down? Does "the market" know something individual investors don't?
What's Not Contradictory The reason things always look so clear in hindsight is because at that point all the warning signs are apparent. Everyone was caught up -- indeed, snowed -- the the promise of the "New Economy" back in the internet age. After the bubble burst, it was only too obvious that the "New Economy" was about as real as the emperor's new clothes. Similarly, everyone was happy to believe that subprime lending would only impact a small part of the market. Analysts spent all winter and spring convincing willing investors that the problem would remain "well contained". Now we know better and can see why these explanations failed their reality checks. The warning signs are here again, and perhaps more importantly, they aren't the source of the current contradiction. On the contrary, they're all remarkably consistent. Back in August when subprime loans began to reset and bankruptcies started to rise, those who owned the paper found few if any willing buyers. Without any bids to establish market prices, liquidity disappeared. Holders scrambled to raise cash by selling other more liquid investments -- generally stocks. Suddenly the subprime crisis wasn't so contained. Feeling the pressure to act, the Fed and other central banks moved to add liquidity to their respective markets. Initially the Fed tried to stick with more limited open market activity, but that was relatively ineffective. In September, they finally moved off their neutral stance, lowering the Federal Funds rate by ½% and ultimately, the Discount Rate by a full 1%. Until then, the futures market had all but discounted no change through the end of the year, but following the cuts, they immediately priced in a 100% chance of at least another quarter-point cut by New Years. Lower rates and the prospect of even lower ones weighed on the dollar. The dollar's strength in the currency market is really a measure of domestic interest rates vis-à-vis those of other currencies. Although other central banks added liquidity, none of our key trading partners took such drastic action as the Fed in lowering key benchmarks. As a result, the dollar declined, sending the euro to its highest value ever versus the dollar. The dollar also fell against the yen while the Canadian dollar actually moved above parity.
Crude oil and other commodities such as gold also moved to -- and in many instances beyond -- decades-old highs. These commodities are typically priced in dollars but their intrinsic value does not rise or fall with global exchange rates. Instead, if anything, high demand for oil in developing nations and gold as a hedge against volatile exchange rates kept them rising in value. As the dollar declines, their prices go up to maintain a constant or even rising value. By late October, crude oil was trading over $90, a new nominal high. The 1980's inflation-adjusted high around $102 is also within sight. All of this is consistent. It's all supply and demand-based market pricing. The subprime crisis was a major factor setting it in motion, but from an economic standpoint, it's what's to be expected under such circumstances. What doesn't make sense is the rising stock market.
Three Possible Explanations There are, however, three explanations for this apparent contradiction: It's All Just Noise -- There are times when events seem exceptionally crucial, yet ultimately prove to be nothing more than a passing headline. With new technologies, the internet age has helped spread such noise at increasingly higher rates. Anyone watching CNBC on any given trading day runs the risk of being whipped into a frenzy over the latest earnings release or economic report. Real news rapidly makes its way around the globe 24-hours of the day and many investors feels compelled to act before analyzing. So perhaps the confluence of negative economic signals is just an odd coincidence without any real depth. Maybe the market is still rising because it sees through this, focusing instead on the resilient domestic economy. It may be telling us that although things are not as they appear, and 2008 will be much better. Unlike individuals who are easily distracted by the most recent headlines, the market remains focused on what's really important, and that's not so bad.
This is the most optimistic of the explanations and essentially boils down to, "The market's right and everything else is wrong." It could be correct, the but the odds are stacked against it. Earnings trends have been on the decline for some time -- not just since August. Crude oil and commodities prices hit almost every consumer every week, and that's bound to have an effect on discretionary spending -- one of the chief engines of the current economic expansion. They're also a source of inflation, especially now that the Fed isn't still holding the line. It's difficult to believe this is all noise. If anything, it paints a pretty compelling picture of a slowing economy.
The Bottom Is In -- Economists look at three types of economic indicators: Leading, coincident, and trailing. The equity market has often been cast as a leading indicator. The presumption is that investors anticipate earnings increases before they're reported. As a result, share prices rise in anticipation of rising profits and the market turns before the economy itself. In the current situation, one might think rising share prices are actually reflecting investors' belief that the third quarter marked the low point in the slowing economy. With all that's happened -- from the subprime credit crisis to soaring commodities and the falling dollar -- the bottom is in. With these negatives already discounted, the coming quarters should show improvement. But looking back over the past twenty years, this relation doesn't really hold up. Earnings often turn after the Gross Domestic Product (GDP) reverses course. In the recession in the early part of the last decade, earnings actually rose for several quarters before finally falling to cyclical lows after the recession ended. In fact, one could make a good case for the S&P 500 as actually being a lagging indicator. Although the correlation between earnings and real GDP is a positive .37, the relation increases to .48 if GDP is lagged by three months. In other words, trends in real GDP are a better predictor of S&P earnings three months out than vice-versa. The concept of stocks as leading indicators may have gone out of favor about the same time as spats. It's hard to believe we've already hit bottom in profit growth when there's still more disappointments and write-downs from the subprime mess yet to be revealed. Momentum -- For the past five-plus years, stocks have been moving up. Each time they've appeared to falter, they've quickly recovered and moved to higher levels. Short sellers, those who bet against stocks by selling borrowed shares in hopes of replacing them when they decline, have been consistently disappointed. Whenever there's an unexpected rally -- and it seems to be happening more and more frequently -- they're forced to buy stocks to cover their positions before their losses mount. This "short covering" only tends to drive share prices higher and add additional momentum. In other words, the market's upward momentum is simply feeding on itself, not the fundamentals. If this is truly the case, it doesn't matter what happens in the credit or commodity markets, stocks are marching to their own momentum drummer. This certainly isn't unprecedented, simply recall the internet boom of the late 1990s. Also recall how that ended with a devastating three-year bear market.
Odd Factor Out Investors entered the third quarter earnings reporting period willing to give financials and homebuilders a pass for poor earnings. The thought was that they'd get their write-offs out of the way and then return to profitability in the fourth quarter. More cynical market watchers expected beleaguered companies to take advantage of this opportunity by clearing the decks of all marginal loans, securities, and holdings thereby almost guaranteeing positive comparisons in the coming quarters.
That didn't really pan out, however with the likes of Citigroup and Merrill Lynch surprising investors with additional write downs. Others are sure to follow as the credit crisis continues to filter through the market. Against that background, it's not likely that the worst is over or the bottom is in. That, of course, leaves the momentum explanation. With stocks solely going against the grain, they're most apt to be the odd factor out. As we saw ten years ago, momentum can persist for a prolonged period of time, regardless of the fundamentals. It's quite likely that's what we're seeing yet again. If the Fed cuts rates again, they'll only do so grudgingly. The weakened dollar is already sparking inflation and lower rates aren't really filtering down to the subprime borrowers who need them the most. It's our sense the Fed would be well advised to stand pat at least through the end of the year. Another cut shouldn't be taken as a positive for either stocks or bonds, but rather as a sign of how dire the economic prospects have become. It wouldn't be surprising to see stocks pull back as investors come to this realization. That's not the end of the world, just an end of the near-term record setting pace. Unless earnings show a definitive turnaround -- which is highly unlikely -- shares are already overpriced. A correction is to be expected. That's not a call for a bear market, either. Many bears fear that growth in the U.S. economy is falling behind that of our European and Asian counterparts. More precisely, they worry that the U.S. is no longer the international leader it once was, being eclipsed by China and other developing markets. Even growth in some European countries now exceeds that here. But this underestimates not only the importance of exports to the U.S., but the role of U.S. investments as safe ports in an economic storm. As we learned last summer when the subprime crisis spread overseas, the international economy is now more highly linked than ever before. Any pullback in U.S. spending will have a major impact on foreign countries' exports. Brazil, Russia, and India may have developing economies and strong growth, but they don't have the U.S.'s appetite for imports. If domestic consumers are removed from the equation, foreign growth takes a hit, too. Good old Treasury securities will look like a great alternative. Count on it. In the meantime, domestic investors should be increasingly cautious whenever stocks move to newer highs. This is perhaps one of the best profit-taking opportunities in ten years. Although stocks may have further to run in the short-term, no one ever lost anything by taking profits. At the same time, it's still probably too early to turn to fixed income. There may be more rate cuts, but even if there are, they're probably already priced into current yields. With 10-year Treasuries yielding less than 4½% one-year CDs are better alternatives. Not only that, when it becomes apparent that the Fed is through with the current easing policy, bonds will be subject to capital losses, CDs won't. No, this isn't the most exciting or rosiest of outlooks, but it is what it is. Stocks have had a nice run in 2007 and it's time to take a breather while the fundamentals catch up. It's highly likely we've already seen the highs for the year, but with less than two months remaining in 2007, that's certainly not the worst that could happen. The Santa Claus rally may be slightly delayed, but it can still make for a happy New Year. Search this site! Just enter you key word or words:
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LTHOUGH THE UPROAR OVER THE fallout from subprime lending has started to die down, the effects will be felt for quite some time. The full extent of the problems are still coming out, and will probably continue until well into 2008. In the meantime, the economy is left with some odd contradictions.
