Read full newsletter: MarketShadows 9/30/12
As we noted last week, the global economy is slowing down, while the stock market continues to perform well. This week, we explore this disconnect in greater detail.
David Rosenberg describes six key variables that affect the stock market. These variables are: liquidity, fund flows, technicals, valuation, sentiment, and fundamentals. (Here Is How Much QEternity Has Already Been Priced In) The relative influence of these factors changes over time.
Liquidity: Quantitative easing (QE) has been supporting the stock market. The latest, QE-Infinity (or QE3), results in a new $40 billion/month cash injection into the Primary Dealers (PDs) accounts.
David’s research indicates that every $40 billion of QE added to the Fed's balance sheet adds about 20 points to the S&P 500.
The chart below shows one way to quantify the Fed's money-printing ways on the stock market:
Describing the chart, Phoenix Capital Research wrote, "the New York Fed itself has openly admitted that were it to remove the market moves that occurred around Fed FOMC meetings [the times when the Fed announced new programs or hinted at doing so], the S&P 500 would be at 600 today..." (Draghi's Bazooka Fired Blanks)
The chart suggests that market participants were front-running the news. But had the increase in stocks been driven solely by anticipation, stocks should have later sold off. They didn’t. The higher prices were sustainable because liquidity was added to the financial system through the PDs--beneficiaries of the Fed’s QE programs.
In a ZIRP (Zero Interest Rate Policy) environment, with the Fed printing money and the Dollar losing value, “risk on” trades became increasingly appealing and money moved into stocks and commodities. The PDs also took advantage of more complicated investment strategies. According to Michael Hudson, the $800 billion QE2 was used by the banks to speculate on currency and interest rate arbitrage. They borrowed money at 0.25%, lent it to the BRIC countries at much higher rates, and then pocketed the interest rate arbitrage. Contrary to story line, the banks did NOT put this money into the economy. “The reality is that ever since QE1 and QE2, every time there’s a loan, the banks reduce their loans to businesses, they reduce their mortgage loans, there’s less mortgage refinancing, and in fact, the banks use the money to gamble, mainly abroad in foreign currency and interest rate arbitrage...” (QE3 = Jobs for Wall St.)
Fund Flows: Mutual funds and hedge funds have been underperforming the S&P 500. These funds have to buy the market to appear like they’re keeping up with the S&P benchmark.
Technicals: Technical analyses have been bullish. (Market Shadows includes commentary by Allan Trends, Springheel Jack and Lee Adler - they have been bullish recently.)
Valuation: Forward P/E ratios have been at the high end of the range for the past 20 months at 14x. The Shiller cyclically adjusted multiple is 25% above historical norms.
Sentiment: The shorter timeframe for the AAII Investment Survey is neutral, but longer term is bullish. David Rosenberg opined, “The bull camp is getting crowded — problematic from a contrary standpoint.”
Fundamentals: The world’s major economies are in slowdown mode. A question being raised in the financial blogosphere is whether the US is in or about to enter a recession. And if so, what is the likely effect on the stock market?
It might be expected that a recession would profoundly influence stock prices because, logically, lower economic growth is correlated with less spending, lower earnings, missed expectations, and lower stock prices. But such fundamentals are just one of many influences on the stock market. Lately, they have not been strong influences at all.
In The S&P 500 and Recessions, Doug Short examined whether recessions have led to declines in the stock market, and/or whether declines in the stock market have foreshadowed recessions. Doug’s chart below shows the market-recession correlation since the mid-1950s, with the daily closes of the S&P 500 overlaying periods of recessions (grey).
The S&P often peaked before a recession began and bottomed before it ended. Four of the nine recessions since 1957 saw the index higher at the end of the recession than at the start.
Describing the chart Doug wrote, "Since the inception of the S&P 500 in 1957, there have been 9 recessions and 9 bear markets (20% or greater declines). However, three bears were not associated with recessions, and three recessions happened without a bear market, although the 1990-1991 recession had the ultimate "near" bear with its 19.9%...
"Market indexes and recessions are two very different data series. The closing price of the S&P 500 is a real-time snapshot of equities. In sharp contrast, recession boundaries are determined many months, sometimes a year or more, after the fact, for both the starts and ends (peaks and troughs). The NBER makes its call after lengthy deliberations over economic data that has been subjected to extensive revisions.
"Economists often make generalizations about business cycles that suggest a substantial commonality among them. But that's true only at a 20,000 foot level (and on a partially cloudy day). Recessions are dramatically different from one another if viewed within their individual economic and market contexts. Exogenous events can play a role...
"The US economic recovery since the official trough in June 2009 has been much weaker than hoped, and there are many financial pundits who agree with ECRI's latest assertion that a new recession is underway, a view which, I would counter, is not supported by the Big Four economic indicators."
The normal business cycle results in periodic recessions, but the character of these recessions can vary widely. The relationship between the stock market and recessions can also vary widely.
Economists and commentators disagree about whether the US is in a recession. Recessions are not declared officially until after substantial evidence accumulates over time. Current signs that the US is in the early phases might be recognized, in retrospect, but that isn’t very helpful in answering the question NOW.
Mish Shedlock argued that a recession in the US began in June: "I am very comfortable with pegging of the start of the recession in June and I expect more downward revisions in GDP and employment are on the way.”...
"Unexpected weakness and downward revisions are hallmarks of the beginnings of recessions. And so it is with durable goods. Economists had forecast a gain, instead there was a 1.6% drop. Moreover July was revised lower as well.
"Bloomberg reports Orders for U.S. Goods Excluding Transportation Unexpectedly Drop: 'There was broad-based weakness,' said Tom Porcelli, chief U.S. economist at RBC Capital Markets... 'What this now means is that capital expenditures are now going to probably fall for the first time since the recovery started. It remains a terribly challenging backdrop in the U.S.'..." (Durable Goods Orders Ex-Transportation "Unexpectedly" Drop, Down Third Month, July Revised Lower; GDP +1.3% Second Quarter; June Recession Call Looking More Likely)
Writers at Zero Hedge are also in the Recession Now camp: "QE1, QE2, Operation Twist 1, Operation Twist 2, a Fed balance sheet that is now expected to be $5 trillion in 2 years, and all we get is a lousy manufacturing economy that according to the Chicago PMI just dipped into contraction, or for all intents and purposes, recession, printing its first sub-50 print, 49.7 specifically,... But not all hope is lost: at least prices paid soared for the third consecutive month... Cue not just recession, but stagflationary recession... Time to start pricing in QE X to be followed 24 hours later by QE X+1. The central bank cartel is starting to lose control."
Whether we are in, on the brink of, an inevitable excursion into recessionary times, the US economy is weak, as are the other major world economies. The race is on to print money and devalue currencies, and this supports more risky assets such as stocks and commodities. This is the current theme of the markets and why the economy and stocks are not moving together. Fundamentals have taken a back seat to Liquidity, and this trend is likely to last into the near future.
"A veritable chorus of large US corporations has chopped their forecasts down a few sizes, citing the China slowdown, wobbly demand from emerging markets, the ongoing fiasco in Europe, or weakness in the US...
"But you wouldn’t know it from the stock markets, which are supposed to predict future turns in the economy better than any other measure, based on the collective wisdom of innumerable astute market participants—or rather computers, algos, and fat fingers. The S&P 500, for example, is up 22% over the last 12 months. A phenomenal run...
"That the CEO Economic Outlook Index evokes the dark days of double-digit unemployment is not a particularly good sign. It crowns a pile of slashed forecasts from bellwether companies. The old-fashioned among us would expect stock markets to have anticipated that corporate downdraft. But that hasn’t happened.
"If QE, QE2, QE3, the bubbly expectations of QE4, and of course QEx have accomplished anything [read... ‘Forceful and Timely Action’ to Nowhere], it is the miraculous decoupling of the stock markets from reality. Gravity can be turned off, apparently, in this new QE world of ours where no one has gone before. But then, gravity has the nasty habit of reasserting itself at the worst possible moment." (The Miraculous Decoupling Of Reality, For Now.)
So when will gravity reassert itself? We don’t know but will be watching for signs of falling debris as the foundation of our house of cards starts to waver.
Also in this week's MarketShadows Newsletter:
Springheel Jack's TA
Allan's Trends - Shorting the Nasdaq
Virtual Portfolio - House-cleaning