David Rosenberg wishes he had been on CNBC Friday, so that he could have debated hedge fund manager David Tepper regarding his thesis that you have to be bullish because the Fed is standing buy to inject more liquidity.
…a very successful hedge fund manager was on CNBC and (between songs, apparently) told viewers that the equity market now was a one-way ticket up. And, second, the durable goods report.
As for this very successful hedge fund manager on CNBC, he laid out two scenarios as to why he believes the equity market is now a one-way ticket up:
1. If the economy sputtered, the Fed would step in and embark on more quantitative easing (QE), and that would propel the equity market higher because it will lead to P/E multiple expansion.
2. If the economy chugs along, then there will be no need for more Fed balance sheet expansion but the stock market will enjoy the fruits of stronger earnings growth.
It’s a win-win!
Indeed, based on the all the emails we received on this CNBC performance on Friday, and given this investor’s recent track record, it would not surprise us at all if a lot of other hedge funds moved in that same direction. It’s quite possible. Then again, how likely is it that one man can move the market today? This is no longer the 1970s when E.F. Hutton was around.
So of course Rosie isn’t convinced…
Too bad we weren’t invited as a guest on CNBC last Friday to engage in a friendly debate with this portfolio manager because he didn’t outline the third scenario, either because he doesn’t believe it or he just plain didn’t contemplate it or he’s simply not positioned for it. That third scenario is that the economy weakens to such an extent that the Fed does indeed re-engage in QE, but that it does not work. So the “E” goes down and the P/E multiple does not expand. Maybe it even contracts since it already has spent the past number of years reverting to the mean as are so many other market and macro variables (for example, the dividend yield, savings rate, homeownership rate and debt ratios). In this scenario, the stock market does not go up; it goes down.
The fact is that QE has only done so much…
Is it possible that QE2 won’t work? The answer is yes. How do we know? Well, because the first round of QE didn’t work. After all, if it had worked, the Fed obviously would not be openly contemplating the second round of balance sheet expansion. If the objective was narrow in terms of bringing mortgage spreads in from sky-high levels, well, on that basis, it did help.
But it did not revive the housing market any more than the litany of other government programs, and the fact that the economy has slowed so sharply to near stall-speed in recent quarters is all anyone needs to know about the true success, or lack thereof, from the first round of QE.
The Fed has cut its growth forecast twice in the past three months and has sliced its inflation forecast three times. This was not was envisaged when the first round of QE was unveiled last year. Normally, the pace of economic activity is accelerating to over a 5% annual rate in the second year of recovery, not slowing down to below 2% — especially with all the monetary, fiscal and bailout stimulus that is in the system.
Here’s the bottom line: if not for the stimulus and the inventory swing, the economy would have actually contracted this year.
We should be sceptical of QE…
There is not enough evidence to conclude that QE will be successful in terms of giving the economy a sustained boost in a cycle of contracting credit and the lingering trauma on the baby boomer balance sheet with net worth down over $100,000 for the average household from the level prevailing three years ago. Japan’s experience with QE, and the limited success it has had, may also be used as a case in point.
Now as far as the market reaction is concerned, it was completely in line with historical knee jerk “don’t fight the Fed” responses. The Fed cut the discount rate 50bps on August 17, 2007 — the cut was intra-meeting before the market opened. Bernanke was getting ahead of the curve and was going to save the day. I got call after call that day to not fight the Fed and indeed the S&P 500 surged 2.5% and went on to gain another 10% by the October 9th high; then reality set in.
In all honesty, when the Fed cut the discount rate repeatedly in the summer of ’07, the widespread consensus was that the Fed was on the case and that a soft-landing lay ahead. Just like today, when so many investors are can be mesmerized by what was really an incomplete set of analysis espoused on CNBC last Friday.
Back in 2007, nobody believed that a recession could ensue absent a substantial inversion of the yield curve. Well, as it turned out, it turned out to be a case of welcome to the vagaries of a post-bubble credit collapse. Today, we hear about a ‘soft landing’ yet again and that it is impossible to have a double- dip recession since they have never happened in the past. That is a dangerous assumption to make — just like it was a dangerous assumption to say that home prices cannot go down because they never have in the past.
To reiterate, I’ve been around the track many times. I heard all the arguments then about what a lower discount rate does to equity valuation. It’s OK. The market rallied 10% and sucked in a lot of folks. The economy was far stronger then too. What everyone missed was the “E” and the failure of the Fed to control it in a credit contraction. Back then the jobless rate was 5%. Today it’s close to 10%. Play this very gingerly. The profit share of GDP is back to a cycle high, so this is no longer a case where modest low-single-digit economic growth delivers a double-digit earnings stream. In our view, assuming moderate buybacks, revenues that grow in line with an anemic nominal GDP trend, and margin compression, it would still leave us with, at best, a flat corporate earning profile for the coming year.
Then the Fed first announced it was going to embark on QE1 on December 16, 2008:
“The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.”
The S&P 500 soared 5% that day and tacked on another 2% over the next three weeks. A great trading rally to be sure, but it was short-lived. It did not stop the market from plunging nor did it stop the economy from contracting in each of the next two quarters. Don’t fight the Fed! We know what happened next.
Here’s the essence of the problem…
Folks, we are in a period of extreme economic uncertainty. The Fed is being forced to be doing something that they don’t even know is going to work. It does not leave us with a very warm and fuzzy feeling.
The market rallied sizably right after the first discount rate cut and after the first QE announcement. These rallies were short-lived, as we illustrated above. To be sure, the rebound in the stock market last year was impressive, but it was not really related to QE. It was when the market began to price out the recession and price in a recovery and the reality is that profit growth did swing to positive terrain in significant fashion, equity analysts were raising their estimates and company executives were raising guidance.
However, the exact opposite is happening now. On a seasonally adjusted basis, corporate earnings slowed markedly to low single-digits in Q2 from Q1 — the extent of the slowing is being masked by continued double-digit gains in the year-on-year numbers — even though on that score, the comparisons are soon to become much more challenging.
Analysts are cutting their estimates right now (though not so much for 2011 … yet) — reducing their profit forecasts on 521 companies in the past four weeks while increasing them on just 391 stocks (see “The Trader” on page M3 of Barron’s). According to our friends at CIBC World Markets, over 60% of 2010 earnings revisions have been to the downside in recent weeks, the highest ratio so far this year, and more companies are reducing rather than lifting guidance as well.
Not only that, but the factors that propelled the economy last year, which was the tremendous government stimulus and the huge inventory swing, are set to the run their course, with little left to help act as an offset. There is at least 1.5 percentage points of fiscal drag coming next year at a time when inventories will likely no longer by contributing to headline GDP growth and we already know that the baseline trend in real final sales is running at less than a 1% annual rate. This is all a prescription for an economic contraction, not expansion, and as such, we actually view our forecast as being somewhat hopeful and perhaps not bearish enough. But we like to keep an open mind.
All we know is that we would be much more convinced over the case of a sustained bull market in equities if consensus views were closer to $70 or $80 on EPS for next year, as it pertains to the S&P 500, than the current $95 forecast, which implicitly assumes either a vigorous uptrend in nominal GDP or profit margins expanding to new record highs. A $95 operating EPS for 2011 is a 14% jump, which is easier to do in an anemic nominal economic growth when margins are at a cycle trough; a runup like this would be extremely rare considering the V-shaped bounce in margins back to cycle highs. We would not advise putting on big bets on either of these developments taking hold.
Maybe, just maybe, we will look back and say, geez, the bond market did have it right, after all — as it did in 1990, 2000 and 2007. And geez, there was probably a reason why consumer confidence was back to where it was in March 2009. And maybe there was a reason why the National Bureau of Economic Research declared the end of the recession but laden with caveats and nothing to say about the contours of this statistical recovery. Maybe we will look back at the current levels of the NAHB housing market index, the consumer sentiment index and the NFIB index and wonder how it is that anyone could have believed a sustained recovery had begun with these metrics at levels consistent with recessions, not expansions.
“As noisy as the near-term may be, a run towards the April highs appears more likely.” These are the words from Michael Santoli at Barron’s (great article too — Jumping to Conclusions on page 17). It may well be the case because after all, the stock market surged both in the fall of 2000 and again the fall of 2007 to new record highs, and both times even as recessions lurked around the corner.
If you have conviction over the veracity of this rally, as impressive as it has been this past month, then absolutely go ahead and put your money to work. That is your right, but only if you have the conviction. We read the total lack of volume as a sign of very little conviction in the institutional investment community and we share that sentiment. It’s not that the market can’t rally, we just don’t have a strong enough conviction over its sustainability. Friday was a case in point where we had a flashy 2.1% rally on 4.3 billion shares traded on the big board versus the five billion daily average so far this year. We endured the worst August for the S&P 500 since 2001 and followed that up with the best month since March 2000 (best September for the Dow since 1939!) — right when the tech mania was about to peak out and roll over.
At the same time, it also pays to assess what the “price” is signalling and everyone has or should have a point of capitulation. If — a big if — the S&P 500 manages to pierce the April highs and does so with: (i) on high volume, (ii) led by the financials, and (iii) confirmed by the transports, then indeed, that will be a very constructive signpost not to me ignored.
However, what if what we are seeing right now is the continued intense volatility as the secular forces of deflation bump against these periodic policy reflation efforts. One day it is another fiscal announcement as the White House did a few weeks ago (shhh… but it’s not a “stimulus”), another day it is a Fed announcement (QE2), and another day it’s another bailout (oh yes, see the latest on the front page of the weekend WSJ — Credit Unions Bailed Out). Maybe instead of going and retesting the April highs, which now almost seems like a given to the pundits we read over the weekend, maybe what we have on our hands is a move to the right shoulder in what looks to be a classic heads-and- shoulders pattern emerging. Hey, in a market governed largely by technicals and sentiment, these things matter. And, as for sentiment, most of these indicators have very quickly moved to “contrary negative” bullish readings. Not only that, but the market has become seriously overbought with almost three in four stocks now trading above their 50-day moving averages compared with one in four earlier this month (see “The Trader” on page M3 of Barron’s).
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