Wall Street's Incessant Rose-Colored Glasses

Submitted by Joseph Calhoun via Alhambra Investment Partners,

All that we see or seem is but a dream within a dream.

Edgar Allan Poe

All things are subject to interpretation. Whichever interpretation prevails at a given time is a function of power not truth.

Friedrich Nietzsche

I was walking down the street wearing glasses when the prescription ran out.

Steven Wright

I think one of the hardest things to learn as an investor is that your opinion isn’t worth all that much. You can believe anything you want but the market doesn’t care. The only thing that matters at any given moment is what the majority believes and is willing to bet their hard earned dollars on. You can think the “Chinese stock bubble” doesn’t matter and you can believe that the “Greek debt crisis” doesn’t matter but if everyone else thinks those things matter then you are going to have to accept that and the market volatility that comes with it. People believe what they want to believe, see what they want to see and at times it seems as if everyone you pass is wearing Steven Wright’s glasses. But that’s the way things are, the reality in which we have to operate and you might as well get used to it.

I don’t know whether the “Chinese stock market bubble” was a bubble or not or whether it was important to the global economy or markets. My logical side says probably not on the latter but I don’t think most people would agree with that perception and as the Chinese market stabilized last week, US stocks found a bid, up over 2% on the week. Considering the lengths to which the Chinese government went to stanch the bleeding, I am pretty sure they thought it was important but if the original sin was allowing the bubble to form then stopping its fall surely hasn’t solved the problem. But then that likely doesn’t matter any more than whether it was a bubble in the first place. If people believe it was a problem and that it has been solved, then it is solved until proven different and markets will act accordingly. Interestingly, what probably does matter – the condition of the real Chinese economy – doesn’t seem to get much attention these days – except maybe in Canada where the Loonie is doing a swan dive and the central bank just cut rates.

Or maybe it wasn’t the stabilizing Chinese stock market that pushed US stocks higher last week. Maybe it was the resolution of the “Greek crisis” that gave people confidence to buy stocks. After all the widely held belief that Greece would exit the Euro and that that was bad – although an explanation for why it was bad was rarely offered – had pushed stocks lower in previous weeks. Or at least that’s what I read in the Wall Street Journal and on lots of blogs.

All I’m fairly certain of is that keeping Greece in the Euro turned out to be negative for the value of the Euro, something which ought to give pause to the folks pushing so hard to keep them in the fold. That the terms offered and accepted by Greece are ones that will likely prevent the country from ever growing enough to pay off the debt is, for now, irrelevant. The Greek problem is solved and off the table. And again what really does matter, the condition of the European economy, gets favorable coverage just for seeming to be getting better. I saw an article earlier this week praising the fact that European exports were up 5% in the first five months of this year versus last year. Not mentioned in the article is that the Euro is worth about 20% less than it was a year ago.

Earnings season is also upon us and maybe that was the source of last week’s strength. Netflix and Google both beat the earnings guesses of Wall Street analysts and were rewarded with big gains in their market value. Of course, estimates for both had been falling – and in the case of Netflix continue to do so – so beating those estimates wasn’t all that heroic but a beat is a beat. A close reading of Google’s report reveals that the price of their main product – paid clicks – is dropping like a stone but that doesn’t matter either. What matters is that Google is working on all kinds of cool things in secret and that their new CFO was able to restrain expense growth to a paltry 13%. Yes, Google sells for 33 times trailing earnings and is growing at about 15% but still it made perfect sense for the company to gain $67 billion in market cap in one day based on that stellar performance. As for Netflix, with its 300 forward P/E, the only metric I could find in the report that was also triple digits was their cash flow. Unfortunately, it is negative and grew more so by a factor of 3. Yeah, yeah, I know. I’m old and don’t get it, yada, yada, yada, it’s different this time, yada, yada, yada.

The biotech sector also merited attention last week as the M&A cycle shifted into high gear. Celgene continued its spending spree paying $7 billion for a company whose main drug – or more accurately their best hope for a main drug – just performed pretty well in Phase II trials that proved absolutely nothing. Another thing the majority believes is that biotech companies are just becoming more scarce by the day. How else to explain the prices being fetched for anything with bio in the name and a drug in the dream phase? The dream phase is that testing period between crude idea and actual lab work. It consists of making up wild guesses about future revenue based on speculative estimates of potential patient pools and going IPO before Phase I trials have a chance to disappoint. It was about a year ago that Janet Yellen of all people, ventured the opinion that small cap biotech stocks were a might overvalued. One can’t help but wonder what she thinks now.

The power, if not necessarily the Truth, resides primarily with the bulls right now or at least it does in certain parts of the market. The NASDAQ broke out last week to new highs but the S&P 500 and even the more speculative Russell 2000 did not. The market’s advance continues to narrow, to concentrate among fewer and fewer names. Bulls will tell you that this is just a pause and the advance will broaden out. And if enough people believe that and there isn’t any convincing reason to sell, they might be right for a while. But at some point the rose colored glasses will come off and someone might wonder aloud why Celgene paid $7 billion for a company with trailing 12 month revenue of $4.5 million. Someone might wonder why Netflix is worth $48 billion and CBS is only worth $27 billion with more than twice the revenue, better margins, a higher ROE and the ability to produce positive cash flow. Until then it’s just a dream within a dream and somebody keeps hitting snooze on the alarm clock.

Comments

[JustObserving]

Is rose-colored a euphemism for manipulated markets?

Can we lend those rose-colored glasses to the Chinese for a few weeks?

[Bank_sters]

If the fed unreserve raised interest rates .5 points the market would fall 2000 points and a chain reaction would ensue blowing every over magined "investor" to hell.  

[gregga777]

The stock market is a con game run by the rich to fleece suckers. That's all anyone needs to know.

[Handful of Dust]

Another Houston energy company files Chapter 11

http://www.bizjournals.com/houston/news/2015/07/16/another-houston-energ...

[tgatliff]

A better way of putting it... The "markets" will do whatever the Central Banks (and their banker overlords) want it to do.   The only fear they have is that people get enranged enough to force in a political solution which put limits on what they can manipulate.  Then they tank the "markets", spread rumors about the world ending, and they get what they want again.  Rinse and repeat.

[I Write Code]

Alhambra has some good writers.

The "market" is just a sponge for trillions in new debt and printing.  Things are different now, the question is how long can they stay so "different" without imploding, and the answer is they've already gone on far longer than anyone in 2008 would have guessed.

The "break" goes back to  1999, derivatives, AIG, etc.

[gregga777]

Wall Street is a Rich man's con game.

Wall Street is a con game. It's run by the rich to impoverish everyone else. The rich fleece the middle class directly via their 401k or indirectly via their pension plans, etc.

The rich are the mortal enemy of the People. All talk is useless as are participating in the USA's obviously rigged elections. The political process, the courts, the government are all owned by the rich. Millions of votes are meaningless to the rich. On the other hand, one bullet means everything.

[sampaine]

A select group of overpriced stocks leads the market higher. Bearish economic data pushes stocks higher because it might keep the FED from acting. Is it 1999?

[polo007]

According to Macquarie Research:
 
http://personal.crocodoc.com/EmsBFiu
 
China’s policy response
 
How different is it to G4 economies?
 
The battery of policy initiatives that were unveiled by China’s regulatory
Authorities in an attempt to reduce the massive rise in equity market volatilities has inevitably raised a question: how different are the tools used by China?
 
Whether Japan (post ’90’s), Eurozone/UK and the US (post ’08) or China today, the key challenge facing policy makers is that given the underlying leverage (in most cases it exceeds 3:1 – public/private debt to GDP), there is simply no room for excessive volatility in any of the key asset classes. High leverage, declining velocity of money and interconnected capital markets is the perfect recipe for a “butterfly effect” (in chaos theory, butterfly effect is the condition in which a small change in one state causes large differences somewhere else), with volatility in one asset class potentially causing major dislocation in other asset classes.
 
Given our view that most economies can no longer deleverage, the key policy objective is the need to ensure (a) limited volatility in the key asset classes; (b) at least some assets need to appreciate (otherwise there would be no room for further leveraging); and (c) avoidance of sustained contraction of nominal GDP. In order to facilitate this objective, policy makers need to ensure ample and constantly growing liquidity to negate declining velocity of money. The volatility in China’s equities undermines this policy “bargain” and requires a policy response.
 
Whilst China’s responses thus far were more direct (rather than working indirectly through incentives), the basic policy tools were not significantly different. As PBoC and CSRC learn and refine their policies, it is likely that over time they would come to resemble more closely what was used previously in Japan, US, UK or Eurozone. Most of China’s recent policies have already been utilized in other jurisdictions: (1) temporary bans on short selling (US, UK, Euro); (2) easing collateral requirements (US, Euro, UK, Japan); (3) opening CBs wholesale and discount windows (US, Euro, UK, JP); (4) direct funding and recapitalization of systemic institutions (US, Euro, UK, JP); (5) direct CB lending to private non-financial enterprises (US, UK, JP); (6) QE-equity (Japan); (7) easing stock buy-back rules (US); (8) pressing national pension/investment funds to buy equities (Japan). There are a number of other tools China has yet to utilize, such as (1) QE-sovereign bonds; (2) QE-mortgage securities; (3) rapid rate cuts; (4) significant easing of mark-to-market accounting (US). One China policy outcome that is different (and arguably most destructive) is stock suspensions.
 
Whilst one could argue that the impact of asset price collapse in Japan in the ’90’s or GFC were worse than anything experienced thus far in China, China’s leverage is higher (or equal to) levels prevailing in previous episodes, the global outlook is uncertain and deflation is stronger. Hence the need to respond is equally urgent and basic tools have thus far been broadly similar to what other regulators used when confronted with rapid decompression of asset prices. However, key to the success of an aggressive policy is the ability of regulators to convince the private sector that measures are temporary and aimed solely at rectifying disequilibrium.

Whilst we do not believe that normal business or capital cycles could be restored or that CBs/regulators would ever be able to withdraw, this is not a consensus view of the West where there is a strong expectation of normalization. On the other hand inability or lack of desire to create and/or restore normality appears to be investors’ consensus view of China. Structural reform is the key to breaking this negative perception. We maintain that China has no alternative but to accelerate reforms, otherwise rising debt, overcapacity and strong deflationary pressures would become overwhelming, with dire consequences for China’s and the global economy.
 
……………………..
 
Whilst one can debate specifics, the key from our perspective is that no country or region in the world (or at least not the major ones, such as the US, UK, Eurozone, China, Japan, Korea) is any longer able to deleverage.
 
Unlike previous episodes in 1950s-80s, the global leveraging process that commenced in the late 1980s (in the case of Japan in the early 1980s), has now raised global leverage levels to 3x GDP (there is now in excess of US$220 trillion of debt instruments outstanding and indeed the number could be even higher on a gross basis). The leverage in developed countries exceeds 4x GDP (with Japan being the highest at over 5x) whilst EM’s are rapidly closing at 2x (and China is ~3x GDP). In order to place this in perspective, global leverage levels in the early to mid-1990s were not much more than 1.5x GDP (i.e. leverage more than doubled over the last two decades).
 
As leverage increased, eventually, the velocity of money dropped and indeed the higher the leverage, the lower the velocity of money tends to become (for example velocity of money in Japan is currently only 0.5-0.6x whilst in the US it is just under 1.5x, though still down from the high in 2000 of 2.2x). The excessive debt in turn generates growing overcapacity (in both merchandise and service market economies, such as too many steel and cement plants, too many hedge fund managers or bartenders, etc) as future consumption was being aggressively brought forward.
 
As discussed in the past we believe that secular stagnation that currently impacts global and regional economies is caused by a unique conjunction of three powerful forces (overleveraging and overcapacity; accelerating impact of the Third Industrial Revolution; and demographic shifts) (refer to What caught my eye? v.36 - Secular stagnation & four horsemen, 6 Feb 2015).
 
Also as we have highlighted in the past (here and here), we see only four long-term outcomes:
 
1. Allow business cycle to go through and thus eliminate excess capacity (highly deflationary and anyone who has undertaken excessive borrowing would suffer);
 
2. Exceptionally aggressive monetary response (far more than what we have seen up until now), potentially leading to hyperinflation to wipe out debt. Whilst this is a very sharp and fast recalibration, it would significantly impact older people and anyone who saved and relies on fixed income;
 
3. Co-ordinated debt write downs (between sovereigns and sovereigns and private sector), accompanied by re-building of monetary system. Whilst this remains our preferred outcome, it is usually easier to do after the war rather than before the war and has significant implications for banking, investment and insurance sectors; and
 
4. Gradual elimination of capital markets, with the Governments and regulators deciding where capital should flow and at what prices. This is pretty much what China has been doing for the last decade and what increasingly other economies are leaning towards (such as nationalization of mortgage finance, student loans, infrastructure loans, SME lending, etc as well as extensive use of macro prudential controls). The reason we tend to call this a “Cuba” option is that it would ultimately lead to misallocation of resources and a collapse in ROIC and ROE (as China is discovering and Cuba discovered long time ago).
 
We have difficulty seeing any other permanent, long-term solutions.
 
However, given that neither the populace nor politicians are prepared to embark on any of the above solutions (for obvious reasons), the default condition is a gradual elimination of capital markets and creation of conducive environments for continuing leveraging.
 
Volatility, however, is the key enemy of continuing leveraging beyond certain level of pre-existing debt.
 
Given declining velocity of money and interconnected capital markets, the key danger is that a flare up in volatility in one market or asset class could easily turn up in another (and sometimes completely unrelated) asset class, with potentially devastating economic consequences, magnified by high imbedded leverage. Hence, whilst the Fed does not target specific levels of SPX or high yield pricing, it clearly does target volatility. The same largely applies to all other CBs and regulators.

[Remington IV]

buy gold