by M. Kevin Flynn, CFA
The word is in. The economy no longer matters. You might think this an inference, perhaps even a deduction, based upon yet another week in which the stock market rallied on bad news and the stock market rallied on good news. All is for the best in this best of all possible worlds, so when economic data is weak it is good because the Fed will soon lower rates and it is time to buy stocks. But if the economic data is good this too is excellent news, because the slowdown is over and earnings will pick up. Time to buy stocks.
Let me hasten to assure my readers that I am not just taking the cynical view. Not at all. This is the inside dope, so to speak, straight from the horse’s mouth, a metaphor very apt to these race-track times in the markets. The word is coming from the floor traders of that august institution, the New York Stock Exchange. On Wednesday past, the 2nd of May, 2007 to be precise, I listened to a floor trader responding to a question about the upcoming jobs report say, “I don’t know that the economic data really matter that much. There’s so much liquidity in the market, I think we can get by any of it.” On Friday the 4th, another trader averred, “for whatever reason, we seem able to ignore any economic news whatsoever.” That same day, prior to the market’s open another floor trader (and owner of her own firm) reacted to the somewhat weakish job report with indefatigable optimism that the market will continue to go up. When prodded as to why, she expressed her firm conviction that come what may, Chairman Bernanke (the Blessed) would do the right thing. What? prodded the questioner. Lower rates? Press his black box (yes, those were the words)? “I don’t know what he’ll do, but I’m sure he will do the right thing,” she gushed. There you have it, dear reader. I may be a skeptic, but I’m not making any of this up. I don’t have to. And that was only a sampling.
At this point the market really isn’t trading on earnings or the economy, it’s surfing the tidal wave of liquidity and trading on its own momentum. Watching the tape, you can see that traders really are just waiting to pounce on the next ride. The economic picture doesn’t seem to be of much relevance, nor are earnings. The market is invincible, and every dip and piece of bear-defeating news should be bought and bought quickly. The Wall St. Journal talked about “panic buying” by fund managers during the week. That sounds like a reassuring foundation for investment.
In a classic late-stage bull market, the market is reluctant to give up the game. Herd opinion doesn’t change easily. This is true at market tops and at market bottoms, and it’s true whether talking about stocks, bonds or advances in scientific theory. When the direction is long established, momentum will easily carry the herd over the first few bumps of deterioration. As conditions continue to worsen, some early accidents will cause some skittishness. But the bad news never comes all at once; the early deterioration will be too limited to give the status quo a serious fright. The herd’s ability to get around the first obstacles will only serve to embolden it. Therein lies the paradox of the end game: what is actually a failure to adjust to reality is seen as a triumph by the status quo. Prices may perversely rise even faster as dangers multiply, giving rise to the belief that the market – or Chairman Bernanke, say – can triumph over anything. If unchecked, faith in a market takes on the overtones of a religious credo and the bubble stage is reached.
This is why you will hear market veterans make what appear to such non-obvious statements as “a 10% correction would be healthy for the market.” They don’t want to lose money any more than anyone else does, but they do rightly fear the fall from bigger heights. Take a bit of medicine now, and it’s easier for the market to recover. The long-term trend may well remain intact. But bubble collapses are painful. Whether they are sharp and swift, as in 1987, or drawn-out and painful as in 1970-1972 or 2001-2003, a lot of money goes away. It looks to me like the Chinese domestic market investors are going to discover this soon. We probably wouldn’t escape the damage.
While it may seem that the stock market is oblivious to the economic news these days, it really isn’t. It’s just got that late-stage attitude that any problems that haven’t taken it out yet, can’t. We aren’t in a bubble yet, but the market is certainly well ahead of itself, and has reached that topping-out stage where it will either correct or start to inflate the bubble.
Some of the classic symptoms are in place. Good news generates an exaggerated validation reaction to the upside. Bad news, so long as the market knew it might be coming, is shrugged off as not being as bad it could have been, and (to the consternation of the bears) is therefore a positive. This is a crucial point, because at this stage only two things can force the market to step back, and one of them is unexpected bad news. In order to keep the rally going, therefore, the market will try to sniff out all potential negatives and talk up the worst-case scenarios, so that when events do happen they can fall safely into the net of not-as-bad-as-it-could-have-been. This is called ‘climbing the wall of worry.’ The market did it with first-quarter earnings and is busily slashing second-quarter estimates to next to nothing. If next quarter’s earnings growth were to drop to 1% (which would be negative in real terms), you can be sure you would hear something like, “despite what the bears say, Maria, the important thing is that earnings are still growing, and the stock market is growing with them.”
In the interests of full disclosure, I’m going to admit here that I’m not a fan of climbing the wall of worry. To me, it rhymes with “soon you’re all going to be sorry.” It’s not a time for investors, it’s a time for traders and hot money. When the market is climbing the wall, the pressure for self-affirmation turns resistance points and valuation levels into targets to be shot down. You can make a lot of money at times like this, if you’re willing to jump in and out (like a floor trader, for example) and/or make big leveraged bets, like a hedge fund. You can also lose a lot of money, because once the wall has been climbed, it gets ugly. To come out ahead you have to take profits constantly and be ready to sell out in an hour, which is not exactly how most people look at their investments. I’ve never seen a market climb the wall and survive. May the current one turn aside in time.
Which brings us back to the other thing that forces the market to pull back, and that is when the weight of bad news finally becomes too much for the market to bear and equities get crushed. One sign is the sky’s-the-limit optimism cited above. Another is that equity premiums shrink to nothing, which has happened. Or the individual investor gets completely hooked and cocktail-party conversation is dominated by stock tips (remember real estate a few years ago?). We’re not at that stage now, not even close, though it ought to be said that we didn’t get there in 1987 or 1970, either. Institutional sentiment is rising to record levels, which is bearish, as is the decline of cash in mutual funds to record lows. The capitulation of short sellers is another warning sign, and Saturday’s Wall St. Journal ran a story featuring a well-known short-seller advising fellow shorts to head for the sidelines. Against that, the fact that April short interest was at record levels got a lot of press. But that was pre-earnings season, and since that time there have been some spectacular short squeezes – Amazon and Rupert Murdoch’s bid for Dow Jones come to mind – and my guess is that the May numbers will come in much lower. S&P puts are still running above red-light levels, but probably reflect an uptick in portfolio insurance rather than a one-way bet on the markets.
The truth is, though, that nobody can ever know in advance when the tipping point will come. This market feels to me like 1987, with the dollar steadily declining, the economic warning lights on for a protracted slowdown, yet the markets and institutional optimism headed steadily up and being fueled by a buyout wave. A correction in May could put that time off, but the ‘sell in May’ cliché is already in danger of turning into another target to be taken out. Absent an external event, like oil going suddenly to $100 or the Chinese market dropping 40% in a week (both could happen), the buyout money is unlikely to dry up before we hit the tipping point.
Where does that leave the equity markets? A good question. I can definitely tell you that the while signs of recklessness are proliferating, that alone won’t take a market down. The markets are significantly overbought, but prices can remain elevated long enough that technically they are no longer overbought. The one thing I can tell you is that unless you’re a day trader, this is not a time to be putting new money into the market. Don’t get sucked in. What you should be doing instead is reviewing your portfolio allocation. Chances are the equities component has probably risen significantly in the last six months. If so, it’s a good time to trim it back to the desired level. And keep on doing so regularly.
The Economic Beat
The last week or so has brought us the usual mix of crosscurrents. On the one hand, we’ve had a surprisingly low GDP number for the first quarter and rather weak reports for jobs, personal spending and construction spending. On the other, March factory orders were above expectations (which will probably raise the final GDP number) and the Institute for Supply Management numbers came in above expectations. The inflation part of the jobs report was positive, but the prices paid number in the ISM report ran worrisomely hot.
The Wall St. Journal ran a prescient article in its edition of Tuesday the 1st, suggesting that months of inventory destocking had left US factories overdue for a spot of reload ordering. The reports on manufacturing and factory orders may well reflect that. Certainly there was nothing in first-quarter earnings reports to suggest that domestic demand was picking up. April’s ISM number has a rather high seasonal adjustment factor, and it might be worth noting that last year’s number showed a similar lift. Given some of the dismal, more recent news from the auto sector and the subdued results of the Chicago PMI, it’s premature to declare a turning point here. The ISM non-manufacturing number has little predictive value and was actually much higher in January, at the beginning of what turned out to be a rather anemic quarter for the economy.
It’s too early to say anything about the jobs number either. It was not a strong number, but one month doesn’t make a trend. It must be said, though, that February and March gains were revised downward and a large portion of the April gains came once again from the restaurant and bar section of the economy, which is also the lowest-paid segment of the labor force. Of somewhat more concern was the weakness in income growth, now that the first quarter bonus numbers have dropped out of the equation. Gasoline prices are at a nine-month high and heading higher, food prices have shot up and there is continued inflation pressure in the production chain. While the softness in hourly earnings may be of some reassurance to the Fed, it’s not going to help the consumer manage higher costs of living.
Finally, there was quite a bit to chew on regarding retail sales. Anecdotally, the news wasn’t encouraging. Target (TGT) warned, Circuit City (CCY) warned (how’s that employee cost-cutting program working out, fellas?), even Toyota and Honda had to report sales decreases for the first time in years. Once again, one month doesn’t make a trend and there may be seasonal factors at play. Still, despite the steady parade of talking heads on CNBC talking confidently about how the ‘mid-cycle slowdown’ is perfect for the market, it’s really only the slowdown part that’s visible.
The earnings day of the week next week should be Tuesday, when among others Cisco (CSC) and Disney (DIS) report. If you want to make bets on the economy, you could do worse than starting with these two companies. Cisco is the defining stock for the telecommunications industry and very much a bellwether for the tech sector, which has seen something of a rebirth in sentiment lately from the market’s relentless pull higher. Its report is likely to be a catalyst for a significant move in sentiment.
While Disney’s valuation is not expensive at the moment, I’m having trouble getting excited about the company. The television segment seems to be doing well enough, especially ESPN. But the film business is going to have trouble duplicating last year’s results (Meet the Robinsons is no Cars), and I wonder about the impact of the domestic economy on the Disney theme parks and cruise lines. They’re expensive products that don’t really fit into the luxury market, and for that reason are more vulnerable to cutbacks in discretionary spending. The stock is also up quite a bit from last year and has put on a good rally recently in the run-up to its earnings report, leaving it more exposed to expectations disappointment. That said, they could always bail themselves out with another buyback program.
Finally, for those who bought Yahoo (YHOO) last week on the Microsoft (MSFT) takeover rumor, you have my pity if not my sympathy. While I’ve no doubt that Microsoft wouldn’t mind boosting their Internet presence with some kind of deal with Yahoo, I just can’t bring myself to believe that Bill Gates would be dumb enough to want to buy Yahoo at these prices. He’s become a great pal of Warren Buffet, after all, and they have a regular bridge game. How is he possibly going to look Warren in the eye and tell him he paid more than sixty times earnings and thirty-five times cash flow for a company that’s losing market share? It isn’t as if either company has the magic Internet formula that might be counted on to turn around the other’s fortunes. If Gates should ever stumble that badly, I’ll be getting on the wait list for the trainload of investors queuing up to short Microsoft’s stock.