From today's Brunch With Dave
The vagaries of an overvalued market is that good news may no longer be good enough — and viewed as an opportunity to take profits. When this strategy occurs en masse — well, look out. And in extremely overvalued markets, it doesn’t take much. Food for thought — think of the risk involved before chasing the performance of the past year.
Of course, when there is fiscal stimulus of 10% relative to GDP in the U.S., and 3.5% of stimulus globally, together with bank bailouts and government support for housing and autos, then it’s a no-brainer that for a while it is going to feel as if the worst is over and that we are entering a new world of prosperity and tranquility, which is what a 17 reading on the VIX index symbolizes (the same level it was at when the market peaked in October 2007, come to think of it).
Nothing could be further from the truth. We have a situation where banks that are allegedly to-big-to fail have been protected, accounting rules changed in mid-stream, the government buying stock in auto companies and financial service firms, buying automobiles, declaring foreclosure moratoria and loan modifications ,which ensure that the real estate market will not clear and thereby forestall price discovery.
The problem is that all this fiscal largesse, intervention and incursion cannot go on indefinitely because there are limits to what the taxpaying public will support in terms of policy. Trying to get people to buy a home when the homeownership rate is still well above the long run average; trying to spur auto consumption when 20% of the households in the U.S.A. are already a three-car family — these policies aimed at reviving a defunct cycle of over consumption is starting to be viewed as a colossal waste of taxpayer money.
No doubt efforts to support the swelling ranks of the unemployed are going to remain critical, not just as income support but to ensure that they can be retrained too. We are already at the point where a record of nearly 20% of personal income is coming from government transfers — the government will have to make some serious choices about how it is going to allocate its fiscal resources going forward because the appetite for more public debt is beginning to wane. The government cannot fight human nature for ever. In fact, all the Obama team has managed to really buy is time.
But it does look like the fiscal tightening morphs into tightening sometime around mid-year because the mathematics with deficits is that if you go from $1 trillion to $1.4 trillion in a year, you just added some stimulus; just to prevent fiscal withdrawal from economy, the deficit for the next year has to stay at $1.4 trillion just as an example. The problem of course is that even if the deficit were to stay at $1.4 trillion that adds 10 percentage points to a federal debt/GDP ratio that exceeds 100% by 2011. Chart 3 shows where the Office of Budget Management (OMB) sees the government debt/GDP ratio heading in the next decade under the status quo — try 107%. Think of the future tax liability that would impose on workers and investors. And think of how quickly voters would be to support the next round of stimulus if the chart below were presented to them.
To be sure, the question gets asked as to what Mr. Market sees that we don’t see. As we said, in the past, market peaks tend to occur when we have had the classic blowoff phase, which takes the Shiller normalized P/E ratio to a level that is 50% overvalued.
Currently, the market is 27% overvalued on a Shiller basis. So, as expensive as it is, it could easily get even more expensive, which would mean a final test of around 1,300 on the S&P 500. This part of the cycle is best left for day traders or massive risk-takers and not for serious long-term investors. The S&P 500 did not hit its peak until October 2007 and for at least a year, was either in denial or completely oblivious to what was happening to the economy:
- Home prices were already down 7% from their highs
- The ABX indices were imploding
- Financials had already rolled over from their peak (as they have already back on October 14 — now there’s a canary in the coalmine!)
- The credit crunch was already in full force as highlighted by the events surrounding BNP Paribas and those two Bear Stearns hedge funds
- The money market had blown up right in the Fed’s face forcing an unexpected cut in the discount rate, followed by a cut in the funds rate
All the while the equity market was still in the process of making new highs and the bears were too busy having an apoplectic fit to hear the derision from the crowd of bulls as to how wrong they were. That is now history; and not too long from now, today will be too.
In retrospect, the bears were not wrong — the market was irrational. And that is with the benefit of hindsight. Everybody thought John Paulson was wrong too in those years when he was positioned for a housing collapse — but he was right, wasn’t he?
Now is definitely not the time to live in the moment, to start hyperventilating and to begin to chase this market to a bubble peak; now is the time to think about what the economy is going to look like in a post-stimulus world because the only thing we know is that the Fed and the government, at this juncture, intend to start pulling back on their support for the housing market at the very least at the end of March. At that time, we will see what the emperor — the U.S. economy in other words — looks like disrobed. And think of how ugly that picture is likely to be if the Beige Book can, at best, describe the current macro backdrop as being “at a low level economic activity” in view of all the government stimulus out there in support of a boom.