The Market Equilibrium Puzzle

MacroAndCheese's picture

This Friday we were treated to another Stupid Market Trick. The first-look US GDP number was announced, and at 2.2% was much weaker than the consensus of 2.5%, but after a brief sell-off the market rallied. The gains were not huge. The S&P rose a small 0.24%, and the Dow even less with a 0.18% gain, but the Nasdaq advanced by 0.61%--not bad for an economy that falls well short of expectations. The composition of the number wasn't any better than it seemed--in fact, the bear-tilting economist Dave Rosenberg gave it a D+. There's only one real explanation for why the market would rally, and that's expectations for QE3.

Given that GDP, what is the stock market worth, and what will it be worth going forward? As a reference point, let's compare the S&P 500 today with its value back at the high, in 2007. On October 11 of that year, the index hit its all-time intraday high of 1576.09 before closing at 1554.41. At that time, the bloated, doomed financial sector represented about 20% of the stock index value.

Now we go "back of the envelope." If the financial sector was 20% of the S&P, then about 315 points of the S&P at its peak were financial (20% of 1576.09, rounded off). Let's assume for argument's sake that of that 315 points, half of that is gone forever due to the crisis, through well-known credit problems, sub-prime mortgage exposure, and foregone business revenues from defunct business units. As a cross-check, the current value of the financial ETF "XLF" is about 40% of its peak price, so this 50% loss estimate is probably conservative.

S&P 500

S&P 500 Earnings

If we subtract out that 157.6 points from the peak value of the S&P of 1576, we get 1418 and change. The S&P closed at 1403.36 on Friday. In other words, adjusting for the big hit to the financial sector from the crisis, we are at virtually the same level today that we were at when the market peaked. (Strangely enough, our high for this year was 1422.38, back on April 2.) In other words, including the writeoff of half of the financial sector, the stock market is unchanged.

But the adjusted peak value is not the only commonality that today's market has with the high back in 2007. Above we see the running quarterly earnings for the S&P 500 over the same time frame. On an annualized basis the S&P is earning slightly more than $100 per year, very close to the same level of earnings that we attained back in the fall of 2007. So not only do we have the same value in terms of price, we also have the same earnings.

So we're pretty much back where we started. The market sold off in dramatic fashion, and has come all the way back. The $64 billion question is, what comes next. As a corollary, we can also ask, what has changed. On that score I see one very positive development, and several negatives.

The good news is interest rates. Back in October 2007, BBB-rated 5-year bond yields, the often-used discount rate for the stock market, were at 5.5%; today they are literally half that, at 2.75%. 30-year treasury yields were 4.90%; today they're 3.12%. The Fed Funds rate was 5.25%; today it's just below 0.25%. 30-year mortgages were 6%; today they're 3.80%. And inflation for 2007 averaged 2.87%; this year the consensus forecast is for 2.65%.

This lower rate environment is of course a huge positive for stocks. The rate that we discount future cash flows is lower, so it makes that cash flow stream more valuable going forward. This is a point that many bears underestimate, or miss entirely. Yes, the P:E today at 14.27 times trailing earnings is not particularly low, but it doesn't have to be. Those earnings are being generated in an ultra-low rate environment. We have the same earnings we had back in 2007, but rates are lower, so in terms of a price to earnings valuation metric, stocks are cheaper.

Consumer Confidence

But those rates are low for a reason, and with the good comes the bad. The Fed has cut rates to the bone to support our economy, of course, and although we're now creating jobs again, there are 5 million less of them today than there were at the end of 2007. Our unemployment rate sits 4% higher than it was in 2007 at 8.3%. To add to the stress, many homeowners are under water, creating a negative wealth effect, and making mobility more difficult. People can't move to Texas where the jobs are because they'd be selling their homes at a loss.

The other big change since 2007 is the transfer of leverage from the private sector to the public sector--our government. Our debt is now nearly 100% of GDP, and our central bank, the Fed, has expanded its balance sheet by about $2 trillion to stand at $2.87 trillion. Now that the transfer has taken place, there is no place for leverage to go; it has to be dealt with. The leverage that has stimulated our economy and spared us from a depression must be reversed.

Which brings us back to GDP, reported at 2.2% this past Friday. Above is annualized US GDP going back to 1996. This chart plots our GDP going back to the beginning of the tech boom in the late 1990s, then through the cycles of the past twelve years. Our GDP has averaged 2.4% over the entire 16-year period. As the regression line shows, however, the trend of our GDP is downward, dropping from about 4% to just below 1% currently.

The downward slope to the regression is not simply a one-off outlier due to the GDP collapse in 2008-2009, during the height of the financial crisis. Even replacing the three worst quarters of the crisis with zero growth, as seen above, does little to change the course of the regression.

Recall that much of our growth during the past two decades, the period following the crisis not withstanding, was increased due to leverage. Particularly during the real estate boom we borrowed cheaply to drive home ownership up to 69% of households from its norm of 64%, and even before our stimulus packages our government began running up a deficit.

What will our GDP look like when the boost from our government is unwound? That is the key question, and for that reason I am rather negative on our outlook over the medium term--for the next four years or so, subject of course to revision. I think it will be very hard for us to grow at the 2.4% we have averaged over the period we looked at, given that the government will have to undo its assistance. There is a trade-off for the government intervention that spared us a collapse. It comes at a cost of future growth, because that assistance not only has to stop, it has to be reversed.

The harder question, to my mind, is when will they take the punchbowl away, and to what extent will the market pre-empt the end of the party? That aspect is key, and it makes for a challenging investment environment. Stocks are not expensive, as we've seen. In fact, shorting them is costly, because at a 14 multiple stocks are yielding about 7%. To make money on the short side the timing of the sale has to be just right.

As we head into May I am happy to keep a small short going, despite the rally of the past few days. The timing of this stance is based on events in Europe, the major factor not under discussion here. If we head downwards I will increase the position somewhat, but the downside of the market doesn't appear to be all that big. The punchbowl is still in the corner, and the line's not getting any shorter.              (All graph sources Bloomberg)


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John_Coltrane's picture

So, you're saying I was too early shorting FSLR at $120 and GRPN at $22?  (Both are going to 0 so you bears are still not too late to the party)  Locating bad/fraudulent companies is so much easier than identifying ones with sound prospects.

silverdragon's picture

Manipulated rubbish statistics, probably not a good idea to make decisions based on them.

Mugatu's picture

Of all the articles I have ever read, this is one of them.

engineertheeconomy's picture

dabadabadabadabadaba said the monkey to the chimp


Boilermaker's picture

Yea, sure, as if anyone actual knows a fucking thing about this shit anymore.

narnia's picture

I'm not sure anyone can put together what it is, but I certainly can put together what it isn't.


disabledvet's picture

what is being missed entirely of course is "this market recovery has occurred without out even a hint of an economic recovery." this during a Presidential election year no less.

Centurion9.41's picture


In the past I have for the most part agreed with your pieces that explain the dynamics and mechanics of the financial profession.

However on this piece, you show yourself to be a classic victim of MBA BS Kool-Aid.

First of all you make a nominal comparison, ignoring the effects of monetary policy on the assets held.  Go back to after the US came off the gold standard, move right a bit to avoid volatility effects of the transition, and THEN adjust the nominal market value for the US$.    Mind you the Fed needs to work the valued of the US$ to ensure it's devaluation is orderly and maintains control over its influence in the global economic system.

As for the classic MBA assertion of discounted future cash flows.  "The rate that we discount future cash flows is lower, so it makes that cash flow stream more valuable going forward. This is a point that many bears underestimate, or miss entirely. Yes, the P:E today at 14.27 times trailing earnings is not particularly low, but it doesn't have to be. Those earnings are being generated in an ultra-low rate environment. We have the same earnings we had back in 2007, but rates are lower, so in terms of a price to earnings valuation metric, stocks are cheaper."

Well that's a nice argument, IF the ultra-low rate environment continues....and it fails to translate the paper value of the S&P to the actual value of commodities needed to actually live.

Algos and BS like DCF formulas are fantasies dependent upon the beliefs they hold as idols.


MacroAndCheese's picture


A correction and a comment:  First, I'm not a victim of the MBA koolade, I'm a victim of shorting the market too early!

On interest rates, I understand your point, but 30-year bonds are not much above 3%, so the market is saying rates are going to stay low.  In Japan, 10-year rates went below 2% in 1998 and have never been above since--in fact, 15 years later, they're now below 1%.  The flipside to that is that their stock market ain't exactly in bull mode.


Lucius Cornelius Sulla's picture

Bonds are 3% because they are predicting asset deflation.  In Japan, Stocks are down over 75% and RE more than 50% ... and it this is 23 years after the peak!  So yes, I think you are correct in having a bearish stance but it ought to be for the long-term.  If we follow the Japan pattern then the S&P will be trading in a range between $400 and $600 for the next 15 years!

disabledvet's picture

we're not only maintaining an Empire but expanding it dramatically. Go ahead..."short this sucker."

Lucius Cornelius Sulla's picture

With 40% of Federal spending being financed by debt and the debt to GDP ratio at 100% (and rapidly rising), there is no easy way to unwind.  It will be chaotic and probably triggered by the dominoes falling in Europe.  Once the unwind starts, it will be very hard to reverse.  The FED has run out of bullets (as evidence by rising inflation) which will make it very difficult for the Federal government to roll over its debt.  Without Federal and FED ponzi debt support, S&P earnings will collapse.  IMO, it is game over.  

“There is no means of avoiding a final collapse of a boom brought about by
credit expansion. The alternative is only whether the crisis should come sooner
as a result of a voluntary abandonment of further credit expansion or later as
a final and total catastrophe of the currency system involved.” – Ludwig von

max2205's picture

Earnings are fake and you know it. Go blow your book some where else.

Fuck!!!! STFU!

bank guy in Brussels's picture

The above 'market puzzle', and the question asked above, « ... when will they take the punchbowl away, and to what extent will the market pre-empt the end of the party? »

Quite exemplifies the discussion in Doug Noland's new piece at the Prudent Bear Credit Bubble Bulletin, springing off from Bryce Elder's FT piece on « ... volatile ‘risk on, risk off’ – or Roro ... »

Noland writes:

« ...The essence of “Roro” boils down to red or black market outcome bets based chiefly on three related factors:  First, there is the timing of policymaker interventions.  Second, is the nature and scope of policy responses.  And, third, the expected near-term consequences of policy measures both from market and economic perspectives. ...

... So, essentially, the marketplace faces a single decision:  Make a big red or black bet or, if you have a functioning brain, do what “still works” – “momentum investing.” ...

... “Roro” is incentivized by short-term speculative market returns, especially leveraged spread trades and other so-called price anomaly “arbitrage.”  “Roro” is antagonistic to long-term investing and real economic returns achieved through investment in capital formation.  “Roro,” a creature of financial and economic imbalances, exacerbates excesses and acts as an adversary to economic prosperity. ... »

'The Many Facets of Roro', 27 April 2012

disabledvet's picture

they will never take the punch bowl away. by all means..."speculate based upon that" of course.