Bronze Is The New Gold And Why Swallowing Aliens Never Ends Well
It's not unheard of for stocks to rally when economic conditions are weak, particularly when corporate profits are doing well; Q2 marked a new all-time high run rate of S&P profits. As a result, the 13% gain in the S&P this year is not a complete anomaly. But, as Michael Cembalest of JPMorgan notes, in prior cycles, 'weak economy' stock market rallies were predicated more on the view that a private sector recovery was just around the corner, rather than the current view that more Central Bank stimulus is just around the corner. The other notable aspect of the rally is that it took place as earnings forecasts for 2012 and 2013 have been falling, and as Q2 revenue growth slowed. To paraphrase what’s going on, Cembalest believes "Bronze is the new Gold" as expectations are so low, that anything better than recessionary data can be well-received by markets.
Here’s one example: on August 3rd, the US payroll report was released. Around 160,000 jobs were created, and the S&P 500 rallied by more than 2%. In this instance, markets awarded a gold medal to a bronze medal performance. That payrolls beat low expectations explains part of it, but in the past, 2% rallies on payroll day only happened when payrolls really took off. The chart below shows each time since 1966 that the S&P 500 rallied more than 2% on payroll day. As you can see, 160,000 jobs is at the low end of historical catalysts.
Another way to think about this: there's so much pessimism around, that a positive surprise can have a positive short-term effect on markets. It's hard to measure pessimism; people try, using investor surveys; put-call pricing differentials in options markets; short interest in cash and futures markets; hedge fund net risk exposure; and the amount of cash on corporate, mutual fund and household balance sheets. The JPM CIO would add a 2% stock market rally on mediocre payroll gains as another indication of elevated investor pessimism as he is reminded of some academic papers showing that the stocks in the Dow rated 'sell' by Wall Street analysts generally outperform 'buy'-rated stocks, and that the same holds true for tech stocks. In other words, capitulating after all the bad news is out can be a bad strategy.
US companies have a lot of cash (note: the largest tech, pharma and industrial names hold around 70% of it overseas), and we are seeing a pick-up in announced buybacks and M&A. But demand isn’t strong enough to merit much of an increase in hiring trends or capital spending. We expect payrolls to average around 150k, and roughly 2% GDP growth. It’s a stable, mediocre trend whose durability will depend to some extent on the election and the outcome of the fiscal cliff debate. On the latter, markets appear to be assuming that the large legislated tax drag on GDP of ~4.5% will be negotiated down to ~1.5%.
Of course, the other factor behind the recent rally is the prospect of unlimited bond purchases (and other financing schemes) by the European Central Bank, as it absorbs the hundreds of billions in sovereign and bank debt exposure that investors don’t want anymore. Let’s use a science fiction lens here. Swallowing an alien is one sure-fire way to get rid of it, but then you have to wonder what happens once it gets digested.
Color me very nervous on how this all turns out in the end.
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