Commenting on the stock market crash and the great bear market of the 1930s, Bernard Baruch was known to have said,
“Had everyone remembered that 2+2 still equals 4 a lot of suffering could have been avoided.”
That wise statement is essentially the problem that we now have today. A lot of highly paid professionals are telling investors that 2+2 = 5 or any other number you want it to equal. I won’t bore you with the market’s valuation problems other than to refer you to the chart of the S&P 500 below.
This chart shows that market valuations were much higher a year ago, but remain high today. The spike in P/E multiples last year had to do with earnings falling much faster than stock prices. Since last year, earnings have improved as companies slashed payrolls to reduce costs. Top line growth has been anemic and there is a general lack of pricing power, so all companies can do is to pare back costs. This means slashing payroll expense. This management tool has enabled companies to improve profits. However, these profit increases haven’t been strong enough to justify present stock prices. As a consequence, the major indexes are still selling at 2-3 times historical multiples with much dimmer earnings prospects.
21st Century Metrics
Because stocks are extremely expensive, it has become necessary to invent new metrics in order to sell the public stocks again. If you are a fund manager, you also need a reason to believe that what you are buying still makes sense. In the investment management business you can never get in trouble by following the crowd. If your peers are speculating and buying overpriced stocks—as long as you do the same—you can never lose your job. Today, professionals and investors are buying stocks based on pro forma earnings, forward earnings and comparisons to industry groups. I actually watched a fund manager on Bubble-TV describe a particular Internet stock selling at 75 times earnings as "cheap" because similar Internet companies such as Ebay and Amazon were selling at over 100 times earnings. The fund manager went on to recommend another Internet company that she also considered to be cheap based on 2007 earnings. I am always amazed that people can be so confident about future earnings four years from now when they can’t even forecast the next quarter with any degree of accuracy.
In a market environment where actual earnings no longer matter, we live with fictional numbers in their place. This is the 2+2 = 5 market. If you watch cable financial shows or get bullish newsletters, you will find several common threads or constants. The first is that pro forma numbers have become the norm—not actual earnings. Restructuring charges, big write downs that destroy shareholder equity and book value are ignored. If the pro forma numbers don’t improve, then you always have forward estimates one year, two years, three years or four years from now to justify paying a higher price. This is an extremely overpriced market and the only way to get around this fact is to talk about other things. That is why there is so much emphasis on pro forma numbers or fiscal and monetary policy. A constant mantra is that the fiscal and the monetary environment have never been this positive. The Fed is pumping liquidity into the system. GSEs like Fannie and Freddie are ballooning their balance sheet with new debt. Refi applications are up 227% from a year ago. Purchase applications are up 17 y-o-y, with recent purchase applications up 15% to the second highest level on record. The dollar has fallen double-digits this year and credit is exploding in the corporate sector again as credit spreads narrow and companies rush to issue new debt or refinance existing debt. America’s credit bubble machine is working over time with new debt added to the system, which is expected to exceed $2 trillion again this year.
The Set Up
It is believed that all of this debt will bring us prosperity and an economic recovery as it has in past cycles. Only this time the credit machine is more pro active. With this much credit and stimulus being created in the system, a much stronger economy is expected for the second half. It is for these reasons that we must now consider another strong showing in the markets this summer before the storm season starts in late September and early October.
I believe a case can be made for another speculative top in the markets before another more damaging trend in the bear market unfolds. My reason for stating this possibility is that there are factors that are now in place that could give us another strong surge in the market indexes. My belief is based on two factors: one of them is earnings and the other is the economy.
Analysts have dramatically slashed earnings projections for the second quarter. This was done at the beginning of the year after companies reported Q4 results from last year. It happened again following Q1 results. Expectations for Q2 are now so low that I can safely say that we should see some spectacular earnings surprises. Companies will handily beat estimates. Companies will lose less money than expected and companies will make more money than expected. That will become the real story. Margin comparisons, top line growth and historic trend comparisons will all be ignored. Beating expectations should provide the bulls with the hype and spin to blow these numbers all out of proportion. We should be able to see some spectacular one-day wonders as a result that should power the market upward along the lines of the long-term trend line as shown in this chart above right.
Besides the better than expected earnings, we should also see some improvement in the economic numbers—albeit temporary. As mentioned previously, refis are up over 227% from a year ago and are up 15% in the latest week. The refi market is still running strong. Add to the refi stimulus the fact that tax checks will go out this month with the reduction in payroll withholding that goes into effect, and more dollars will be put in the hands of consumers. This should be enough to give us a temporary bounce in the economic numbers, which will then be extrapolated as an economic recovery that is now going into full swing. The combination of earnings that are better than expected and an improvement in the economic numbers should be enough to ignite another speculative orgy of stock buying in the market. John Q. is coming back into the stock market again and Herbie Homeowner is extracting more equity out of his heavily mortgaged home.
What Do The Experts Say?
I know that a lot of technicians as well as fundamental analysts have been citing the mania-like sentiment in the market. We have seen an increase in the number of professional advisors who are now bullish, the number of individual investors who are bullish and the ratio of bulls to bears. However, as the Decision Point chart below of bulls to bears indicates, bullish extremes can exist for long periods of time. You will notice that the bull/bear ratio hit an extreme level in 1986 and then again in 1987. However, the S&P 500 nearly doubled during that period before the stock market crash in October of 1987.
I find it interesting that we are in a similar period today. Since last October the dollar has fallen, bond yields have plunged and both stock and bond prices have risen. At the same time the CRB is up, energy prices have risen, and the price of gold is up once again this year. This is exactly what happened between 1985-1987 until April of ‘87. In April of 1987 bond yields began to rise steadily from 7% to over 10% by October. Then we got the crash.
Historical Patterns Apparent
History has a way of repeating itself, perhaps never exactly in the same way, but often enough to alert us of patterns. I can’t help but see a similar pattern today. Earnings expectations have been reduced for Q2 so it is not hard to see how they will be exceeded. Everything is now back-loaded into the second half of the year as they have been the last four years. There are major bets that have been placed on the second half of the year.
What happens if the economic bounce fizzles and sales and profits begin to deteriorate again? If that happens, there is going to be a serious adjustment that will be made in the markets. The possibility of that happening is increasing as consumer and corporate debt levels hit a brick wall. What rabbit trick will policy makers then pull out of their hats?
The problem is debt. There is too much of it at the corporate and consumer level. You can’t build prosperity based on accumulating debt. No other country in the history of the world has ever been encumbered by this much debt before. Why do we in this country think we are any different than any other empire that has gone before us?
Too Much Could Be Too Late
If interest rates have bottomed or worse, if they start to rise as they are now doing, the refi and housing boom will come to an end. Then what is left to grow the economy? The U.S. trade and current account deficit has created a world-wide credit boom that has wrecked havoc and created asset bubbles everywhere it has landed. It has created a glut of excess capacity globally in just about every industry. There is simply too much capacity and widgets around the globe. This is hurting corporate profits, impeding new investments and creating deflationary pricing pressures globally. The problem is that America’s recycled trade deficit dollars have been recycled back here to the U.S. Foreigners have been reinvesting their dollars into our bond market, our stock market and our real estate. The reason they are doing this is not because they think the U.S. offers superior investment opportunities. They are doing so in order to neutralize appreciation of their currencies. When they receive our dollars in exchange for goods that we purchase from them, they can either exchange out of those dollars into their own currency or invest those dollars here. By investing those dollars here, they keep their own currency from rising which would hurt their export business.
As a result, our cumulative trade deficits of $3 trillion will only get larger and become unsustainable. Foreign institutions will then have to make a decision to either fund reckless credit creation here in the U.S. or pull out and go elsewhere. The U.S. credit bubble will then come to a screeching halt. It can come to a halt simply by refusing to invest existing trade surpluses, much less pull out or sell what they already own. A trade deficit that is now running over $500 billion, if reinvested here in the U.S., will give foreign institutions control of over 50% of U.S. Treasury debt within a few years. This trend is unsustainable. A trend has already begun to diversify out of the dollar, which is why foreign currencies are moving up and the dollar has been moving down. What could accelerate that trend is a shattering of the new economic paradigm or second-half recovery myth.
Consumer & Corporate Debt Soars
Given the economic facts that the U.S. recovery is based on constant credit creation to feed and sustain it, a problem arises when the carrying capacity of debt holders reaches a limit. Rising consumer indebtedness is continuing to fuel consumption in the U.S. A report out today on consumer credit shows that consumer debt soared in May by 5% as consumers racked up more car loans and credit card debt. The May increase brings consumer credit to $1.76 trillion. Some are beginning to wonder how much longer the consumer can continue to hold up the U.S. economy. Consumer spending now accounts for 88% of GDP. We are seeing that those same consumers are now starting to have a very hard time servicing that debt as the unemployment rate continues to rise. Companies may be able to reduce costs by firing more workers, but how are the fired workers supposed to sustain spending? It is one more example of the 2+2 = 5 thinking in today’s economic circles. Companies increase profits by firing more workers. These fired workers then go deeper into debt to buy more consumer goods. While consumers are expected to continue borrowing more money in order to consume, companies are expected to increase their investment in plant and equipment even though utilization rates are barely above 60% in technology and only 74% for manufacturing. It is one reason why this recovery won’t have any legs and why it should hit a brick wall this fall.
Trading Rally for the Stout-hearted
Going back to my 2+2 = 5 thesis, the strong possibility for a nice summer rally leading up to a speculative top and blow off still remains probable given the hype, spin, and hope that have been placed on another second-half recovery. Therefore the question remains how to best play this scenario. As I mentioned from the very beginning in March when I expected to see a rally unfold, it would be a trading rally only—one I believe that is best played by professionals or those who are adept at technical trading. You could speculate by going long the exchange-traded indexes, which are easy to trade. This is what I recommended in March and what I would recommend now if you are so inclined to speculate. Keep in mind that this is and has been a technically driven market rally. The market is moving up on strong technicals, not fundamentals. If fundamentals or value were used, this market would be several thousand points lower now for the Dow. If you are a trader, you better have complete control over you emotions and tight stops on your trades. I have seen too many traders get slaughtered over the last three years in this market believing each new low in the market was the bottom.
Danny Day Trader, Herbie Homeowner, Larry Lawnmower and Slick Speculator Hoping to Roll 7s
Judging by the kind of e-mails I get these days, the general public is moving back into stocks believing that we are experiencing a new bull market. No one understands the debt or valuation issue. If they did, they would be scared out of their wits. The other day I received a phone call from a potential investor that sums up the current state of the market. This individual had lost half of his net worth in the stock market decline of the last three years. He still held on to his tech stocks such as Cisco, Intel, AOL and a few Internets and Biotech stocks. He was encouraged by what he was now starting to see in the price of these shares. What he wasn’t able to do and why he sought out my counsel was that he had no control over his emotions. Therefore, what he wanted me to do was speculate in the market for him. He felt that a professional would be able to buy and sell at just the right time. Somehow he felt that we professionals were in possession of a magic black box that enabled us to buy at bottoms and sell out at tops. His goal was that he wanted me to win back all of his losses. That is what I believe is now going on in the market. Danny Day Trader, Herbie Homeowner, Larry Lawnmower and Slick Speculator are going back in the market again hoping to roll 7s.
Two Ways to Play It
Well, there are two ways to play this scenario out. The first is to technically trade this market. You better be a master of technical analysis if you do and you better be capable of controlling your emotions when the speculative frenzy is at a peak. A caveat—if you think you have become a master—beware of the unexpected. You better have some gold and silver in reserve as a hedge against ten-sigma events. The possibility of an unexpected event increases each day with geopolitical risks accelerating along with debt and speculation.
The other choice is to go with the new emerging bull market in things. As you can see in the charts below, the price of energy, metals, and commodities are rising. Gold prices are up for the third year. Oil is hovering over $30 a barrel. Natural gas is still over $5 and we haven’t hit winter weather yet. Foreign currencies are up double digits this year and the dollar is still down for the year with the trade deficit accelerating. Monetary and fiscal conditions are creating a fertile environment for hard assets, not to mention fundamental supply and demand conditions which are also bullish.
I have stated before that an investor can do well at investing by making only a few key investment decisions in their lifetime. If you can get on board a new trend before others have discovered it and then ride that trend until it plays itself out, you have the key to great wealth.
You now have a key decision to make. You can continue to speculate in this bear market rally hoping to get out at its top or simply get on board a new bull market in things and ride that trend as it plays out over this next decade.
I would like to end by quoting something that William D. Gann wrote a long time ago that is just as relevant to today’s market.
“No matter how strong a man’s will power may be, he is influenced, consciously or unconsciously, by what he hears or sees, and his actions or executions are interfered with accordingly….Anther fact that traders overlook is that the more times a man gets in or out of the market, the more times he changes his judgment. Therefore, the percentage of his being wrong increases…He must wait until he has real cause and sufficient reasons, based on facts, before he makes a trade…The daily moves generally mean very little to the main trend of the market.”
Today's Market
Markets stumbled today with the exception of the tech-laden NASDAQ, which managed to squeak by with a gain of one point. Decliners outnumbered advancing issues by 18-14 on the NYSE; while winners beat out losers on the NASDAQ by the same margin. Volume hit 1.56 on the Big Board and 2.07 on the NASDAQ. Money is coming into the market even while stocks are undergoing distribution. This market has strong technical legs now that the general public is being sucked back into the market.
Yahoo reported profits after the closing bell missing estimates of $.09 a share. The company reported earnings of only 8 cents. Net income rose from $21.4 million to $50.8 million on revenues of $321.4 million. The company raised its forecast for revenues for 2003 to $1.31 billion from $1.28 billion. The sales estimate was below analysts projections of $1.33 billion. The stock which has risen 177 percent over the last 12 months trades at 122 times trailing earnings and 99 times next years estimates. It sports a prices/sales ratio of 19 and price to cash flow of 60. The stock has 7 buy recommendations, 10 holds and only 5 sells. Two analysts that follow the stock have just issued strong out perform rating for the stock . A few others are calling the stock cheap at present prices. The average P/E multiple for the stock is 277. This stock once sold at 1047 times earnings back in January of 1999. Based on historical comparisons many think the stock is a buy. As I said earlier this is a 2+2=5 market. So P/E multiples of 121 look cheap if only by comparison to P/E multiples of 277 or 1047.
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