Market May Get Cheaper, But Tail Can't Wag the Dog Forever

There has been a lot of talk lately about the velocity of money, and how it has slowed down dramatically leading to most of our current problems (the subprime crisis caused the decrease in velocity, the decrease in velocity caused the economic crisis). The velocity of information, meanwhile, has been constantly increasing.

CNBC is only too happy to tell us, between commercials for the Snuggie and sterile catheters, that they are getting a record high number of viewers every month (ditto for sites like finance.yahoo.com and finance.google.com). The economic collapse is forcing more people to look for answers, which in turn is forcing reporters and analysts to manufacture them.

The truth of the matter is there is one very simple reason why the stock market goes up or down on any particular day: supply and demand. Sometimes buyers are more aggressive, sometimes sellers are more aggressive. Is knowing that the jobs number is crappy really a reason to buy or sell the market? We already knew the jobs numbers were going to be bad. Is a build in oil inventories really so shocking that oil is worth 10% less? We can already see oil is in huge contango (meaning you are being paid an above average return to store oil), so it’s only natural that inventories are going to keep increasing. As long as it makes more sense to sell tomorrow than today, people will do that. If oil inventories decrease while there is a huge contango then that would actually be something newsworthy.

Six million barrels of oil (when 85 million barrels are used per day, and hundreds of millions trade per day) affected the price of oil by 10%. Over the longer term those 6 million barrels won’t matter, it will be the true supply/demand fundamentals. In the short term the “tail can wag the dog”.

The most important thing that you need to do (which I’ve been trying to emphasize in my previous posts about the S&P 500 and earnings yields) is to filter out all the day to day noise and look out toward the future. The charts that I included a few days ago show that stocks are cheap relative to Treasuries. The chart below (from ”The Big Picture”, who got it from FusionIQ) shows that investment in equities is at 20 year lows, which could be taken as a sign that most of the people who want out are out.

Click to enlarge

I don’t know what headline will come out today or tomorrow or next week that will spark a short term frenzy of buying or selling. What I do know is that there was no one headline that caused the market to turn over in 2000 or 2007, and no one headline that caused the market recovery in 2003. There was just a combination of things that made the current prices in the market unsustainable. We are at that point again in 2009. The market is unsustainably cheap. Could it get cheaper? Sure, in the short term, but remember; the tail can’t wag the dog forever.

Disclosure: Long Position in Oil

Comments

[shark1001:]

Totally in agreement.

Jan 13 07:31 AM

[P29:]

What is the source of this chart please?

Jan 13 07:42 AM

[Royal Scot:]

Another pitchman flogging the 'stocks are cheap - time to buy!' line.

Look to the future? I don't see anything in the future but dark clouds. The stock market has to exist in the same economic reality as the rest of us.

There are 'a combination of things' in play right now that make the market cheap, but I submit they are very sustainable since they are very real.

Jan 13 07:51 AM

[Conan the B...:]

Earnings forecasts continue to be lowered by the companies themselves, Analysts are playing catch up, they are not forecasting.

Problems in the Financial sector persist, Deleveraging continues, more cockroaches seeing more light.

Oil Inventories in the USA at 10 year highs, But you see a light at the end of the tunnel. I see one too. Its the Midnight express.

Jan 13 09:24 AM

[Ishortyou:]

Russia and the Middle east feed on oil, it's imperative that we develope new technologies to makes us fossile fuel independent to send them to the stone age, if we go green first and fast we will survive, so lets stop being spoil brats and start growing up!!!!!!!

Jan 13 09:46 AM

[axelrod608:]

>> "Another pitchman flogging the 'stocks are cheap - time to buy!' line" >>

NO. There's a world of difference between pitching "cheap" and looking at long term vs. short term circumstances. Question - will people keep using oil in great quantities ? Answer - yes. Will marginal producers slow/stop production if prices drop below their cost of production ? It has already happened.

Current inventories are a temporary condition. Long term - 5 or 10 years - supply/demand will stabilize. And if the speculators do what they did last year when equilibrium is reached, we could see another bubble, but it's less likely. Unless as the author points out, people focus on the daily "news" rather than on long term fundamentals.

>> "The economic collapse is forcing more people to look for answers, which in turn is forcing reporters and analysts to manufacture them." >> One of the better one-liners I've seen in a while. Oil is the backbone, the foundation of the world's economy. Just because oil stocks are getting drubbed now won't change that fact. And whether current valuations are a temporary bottom or the ultimate bottom, now is not a bad time to dip one's toe in the water.

Jan 13 10:44 AM

[John Lounsbury:]

Nick Abe - - -

You wrote: "The charts that I included a few days ago show that stocks are cheap relative to Treasuries." You are arguing that stock should rise in response to this fact. Why couldn't the ratio return to normal levels by Treasuries falling in price?

You graph shows 1987 to date. I would argue that conditions in 2009 are more like 1974 and 1932 (and possibly 1941?) than any of the market bottoms you have cited.

I think many of the commenters are correct in questioning your analysis. The work is, in my opinion, good analysis. It is simply incomplete. Maybe you can flesh it out in another article.

Jan 13 10:56 AM

[Conan the B...:]

Instead of focusing on Bull Market Valuations, you should look at what Bear Market Valuations were on average.

Since a similar Bear hasn't been seen since 1982, I would be looking at the valuations at the Bottoms seen in 1975 and 1982 for a more realistic view.

We are nowhere near what would be considered "cheap" in that context. IMO

Jan 13 11:32 AM

[bobbobwhite:]

You are right as far as it pertains to average market P/E in those years but not dollar prices. Inflation has to be factored in order to be sure we are comparing big, red, juicy apples to big, red, juicy apples.


On Jan 13 11:32 AM paultaut wrote:

> Instead of focusing on Bull Market Valuations, you should look at
> what Bear Market Valuations were on average.
>
> Since a similar Bear hasn't been seen since 1982, I would be looking
> at the valuations at the Bottoms seen in 1975 and 1982 for a more
> realistic view.
>
> We are nowhere near what would be considered "cheap" in that context.
> IMO

Jan 13 12:01 PM

[sa44ron:]

The tail can't wag the dog? Try and tell that to the FED. They have been wagging the economy and the currency markets for at least ten years. Remember: the Asian currency crisis, the Russian ruble crisis, Y2K, the 2001 recession, the 2009 recession. They flushed the system with money and what did we get: the Tech bubble, the Real Asset (gold, commodities, real estate) bubble, the cash (US Teasury)bubble. Now they are going to buyback US 30-year long bonds to force future interest rates lower and float the US real estate market. So now where is the 'hot money' going to go? Into long bonds?

Who said I won't get fooled again?

Jan 13 12:23 PM

[1422moboggie:]

I definitely agree that our saving Grace is going to have be producing more alternative energy means and going green but something that troubles me most is when I WAS A KID we had an incinerator attachment to our furnace that eliminate more that took to the curb.Isn't there some old ways that we are overlooking using to making working solutions,today.
so if someone wanted to make a good return on a short-term investment in this market, what wouldyou recommend? There have been so many changing tides...I know definitely a yacht over a rowboat even with a strong motor.
Low prices on oil and higher prices on food and healthcare as well as prescription drugs.

Jan 13 12:29 PM

[James Levy:]

Good analysis, thanks. I would add that CNBC and the majority of the media outlets are now emphasizing the bad news, and giving little or no attention to any good news (for example, the lower initial unemployment claims) in order to set the lowest possible starting point for the ¨Chosen One¨, President Obama. In the coming months, after Socialists Nancy Pelosi and Harry Reid have increased dramatically the reach of the government into the lives of all Americans, the news flow will become more positive. Articles in the New York Times and The Washington Post will eagerly highlight any and all signs that the brilliant Obama plan is working. Hold on, the left wing media will insure that the Obama Age is perceived to beone of unprecedented prosperity, no matter what the cost in new debt and erosion of individual liberty.

Jan 13 12:47 PM

[Conan the B...:]

bobbob: Please define PE ratio.

Has the definition ever changed?

Jan 13 12:52 PM

[BrucePile:]

If you were to superimpose on the chart above a graph of the total debt level from the mid '80s to now, it makes the neat cycles of sideline cash at '87, '90, and '02 less meaningful to the trip there now. The decades long global debt bubble build and present collapse is what's driving the markets, not the smaller scale cycles of those three previous years.

Jan 13 08:37 PM

[{5U}:]

If Billy Mays pitched stocks, we would be at DOW 12,000


On Jan 13 07:51 AM Royal Scot wrote:

> Another pitchman flogging the 'stocks are cheap - time to buy!' line.

>
>
> Look to the future? I don't see anything in the future but dark
> clouds. The stock market has to exist in the same economic reality
> as the rest of us.
>
> There are 'a combination of things' in play right now that make the
> market cheap, but I submit they are very sustainable since they are
> very real.

Jan 13 09:37 PM

[jepittman:]

1974 may offer a comparable situation to today's market. It had a similar 'waterfall dump' that is somewhat contrary to the gradual decline of 1981 - 1982. In both cases however stocks were cheap and patient stockholders reaped large rewards by refusing to panic along with the crowd.

IMO Treasuries are unlikely to decline dramatically until the global economy shows unmistakable signs of a sustainable recovery, and the Federal Reserve is not a threat to monetize virtually unlimited amounts of treasury debt.

Bearish investors today are earning virtually nothing on taxable riskless short term securities and CD's. Chairman Bernanke has unmistakeably signaled this will be the case for the forseeable future. Futures prices are confirming it. Security valuations are low by historical standards and shortsellers initiating positions near today's levels are fighting the Federal Reserve.

Despite conventional wisdom, especially among posters to SA, the US dollar has held its value versus other currencies in the developed world quite well. In spite of the problems facing the USA, there are arguably greater problems facing Europe and Japan. Recessions facing these large economies are at least as daunting as in the USA and look to be deeper and more protracted. The highest probability is for the US to exit the recession far sooner than the other developed economies, which explains much of the dollar's recent relative strength.

I do not mean to belittle the problems and difficulties facing the US economy and its markets. They are indeed severe and have been noted by numerous posters on these forums. I would submit however, it is precisely these problems that have given rise to the highly unusual opportunities present in today's markets. If all were well, prices would never be this distressed.

As the author says, "the markets are unsustainably cheap". The Federal Reserve is determined to reflate not only the US economy but all economies connected to ours. Because the dollar is the world's reserve currency, all modern economies will follow. We will either recover or decline together. The world's central banks say "RECOVERY", and with that will come substantially higher risk asset prices.


On Jan 13 10:56 AM John Lounsbury wrote:

> Nick Abe - - -
>
> You wrote: "The charts that I included a few days ago show that stocks
> are cheap relative to Treasuries." You are arguing that stock should
> rise in response to this fact. Why couldn't the ratio return to normal
> levels by Treasuries falling in price?
>
> You graph shows 1987 to date. I would argue that conditions in 2009
> are more like 1974 and 1932 (and possibly 1941?) than any of the
> market bottoms you have cited.
>
> I think many of the commenters are correct in questioning your analysis.
> The work is, in my opinion, good analysis. It is simply incomplete.
> Maybe you can flesh it out in another article.

Jan 13 11:09 PM

[John Lounsbury:]

jepittman - - -

Excellent summary argument. I may disagree with you, but only on the timing. I am not ready to buy very many of the bargains yet, mainly because of very poor earnings visibilty and my fear that visibility may remain poor for several quarters.

I gave your comment its first thumb's up based on the quality of your argument.

Jan 14 12:01 AM

[Conan the B...:]

John: I'm going with the 74-75 waterfall which took 2 years to complete from top to the start of the next cyclical Bull.

This, for me, is an October final bottom, or another 9 months of backing and filing, more Backing if H. Ruff is right about a Depression or Depression-like symptoms before any signs of inflation.

DZZ has had rising tops and bottoms since its inception.

If you want insurance, this is better than most.

PS. I left another post similar to this elsewhere, I expect a lot of rants. But I also can't wait for all of the Conspiracy cries as Gold gets reamed.

A lot of people have been spinning that the Backwardization of Gold means strong demand. I have an entirely different take. Lower Future Gold prices mean that Gold is predicting lower inflation. Why buy gold now if you can buy it cheaper later. IMO

Jan 14 04:27 AM