A couple of weeks ago I wrote an article expressing fears about the equity market. While I would rather be writing about why investors should be piling into the market, I feel compelled to take up the theme again. There is reason to read on.
One of my more lamentable habits is that of checking my smartphone in the middle of the night for news from abroad, as well as indications in the futures markets (although it must be said that some stories are very helpful in retuning to sleep). I also check the futures market and European markets again immediately upon rising.
What plagues me of late, thanks to these nocturnal habits, is the sensation of disconnect between the rest of the globe and the markets. I've experienced this feeling before, and cannot remember a time when it didn't end in a bad way. Obviously one has to make allowance for the fact that the media isn't in the business of trying to publish boring stories, but I've been around long enough not to bite at every hook.
One has to make other allowances as well. Despite its ill-deserved reputation for being a discounting mechanism, the stock market does not in fact closely follow the twists and turns of the economy, or even corporate earnings. It often doesn't follow them at all, and in my experience the things that markets do decide to follow change over time. That said, in the long run prices do eventually come back to both the real economy and corporate earnings, though the timing is often surprising and the herd-driven gyrations more than a little erratic.
But before I discuss the disconnect, let me first give you some reasons why the market is going to try to track higher in the near term. The current rally has momentum, the calendar, and the narrative on its side. Sentiment is what drives investors to buy and sell, and momentum is the dominant short-term influence. I think you know the current direction. The calendar tells trading programs that buying is still the default action, at least until next month. The narrative is that central bank action protects and nourishes equity prices.
Whether you think it's because low yields leave no alternative, or the rally is liquidity-driven, or manipulated by a secret conspiracy of evil bankers doesn't matter. So long as enough marginal buyers buy into the end conclusion, the gradations on motive are moot and largely irrelevant so far as price is concerned.
Furthermore, as many know and as I've often noted, the tape makes the news. A rising market creates its own halo over events. Any increase in any data series can be labeled as a major positive signal when the bull has the bit in its mouth. Decreases can be just as bullish, because they only serve to invite further central bank salvation.
In the wee hours of last night, or the early morning hours before the open, there were a number of stories of interest. The Cyprus rescue pact fell apart, and the country's banks and stock market will remain closed for the week. Because the mandatory tax on savings was rejected, this was somehow interpreted as a good thing. I remember quite vividly when the other major banks did not want to get involved in any support mechanism for Lehman Brothers. That worked out well. Perhaps if Cyprus can be persuaded to shut its banks and stock market permanently, we could get an even bigger rally.
Other items recounted that Italy still has no government and its financial system is in dire straits. Spanish Prime Minister Rajoy is preparing fresh downgrades of the country's outlook. The French economy is slipping deeper into recession and is the smart-money favorite to throw a piston rod this year. The UK cut its outlook in half, the pound is taking a beating and the Bank of England's governor was voted down in his quest for more accommodation.
Fedex (NYSE:FDX) announced lower net income, lowered its outlook, and its net freight tonnage is down. Caterpillar (NYSE:CAT) announced another sales decrease and said global retail sales are dropping.
Along comes Larry Fink, CEO of Blackrock, to tell us that Cyprus is too small too worry about, and that stocks will be up 20% this year, a bit of news relayed in an awed voice by the Bloomberg newsreader. Really? Here is Chairman Larry telling people that Lehman was safe (Blackrock had just invested in them) and that it was time to start buying subprime paper in June of 2008. Good timing, that. I don't mean to pick on Fink, who after all has made a much bigger pile of money than yours truly. But he is a vendor, and his exhortations to buy have to be seen in that light (by contrast, here is my own take from June of 2008).
Other familiar, late-rally notions are circulating. For example, the wealth effect of the rising economy will propel the economy higher. Yes, just like it did in 1999 and 2007. The market will rise because of multiple expansion, due to nothing else good to invest in (an assessment included in Fink's 2008 interview), and because the central banks will save the market (cf. October 2007, spring 2000). Corporations have more cash than ever and profit margins are peaking (2007 again).
Two stumbling blocks remain ahead for stock prices. One is that the narrative of the tape will soon hit a snag, my guess being in late April. If you're wondering why it will take so long, I've a couple of reasons in mind. One is that the S&P 500 is forming yet another cup or cup-and-handle pattern, and in bull markets these are absolute magnets. You should expect another burst of money to pour in for the last run to the record high and quite possibly past 1600.
Another is that there is no reason to suppose that the process that inflated February jobs is going to disappear in one month. What's more, Easter comes at the end of this month and is one of the holidays that incite people to spend for the family, whether it means reaching for the charge card or borrowing money from paycheck lenders. Weekly sales are already moving up. The March retail sales report will be the next installment in the annual spring "escape velocity" saga, though it will only mean that Easter came in March instead of April.
But corporate earnings are going to be weak again (apart from housing) next month, and the end of April earnings season is a dangerous time for equities. If the S&P is over 1600 entering earnings season - and it will be, unless Europe intervenes - the heights will have trouble maintaining the facade of a great economy. In case you haven't noticed, trade is falling around the globe in places like China, Japan, the EU and the United States. When US business spending eases from the first quarter rebuild, the second quarter is going to look bad again, despite the annual prognosis that we're going to make it all up in the second half of the year.
All of that should lead to a correction, but a garden-variety correction isn't why I fear for equities. There are two things that can eventually devastate equity investors in the current market environment - valuations, and credit. The reason I say valuations is that crashes come from heights. Before you can have a real crash, the markets have to climb too high first, and four years on into the current cycle we are neatly on our way there. Adam Parker threw in the towel this week - something I call, "seller's capitulation."
Despite its wretched economy, Japanese investors have the central bank bug too, and the Nikkei is at a 4 1/2 year high because - the new central bank governor is expected to launch an attack on its currency. You have to get high up on the ladder to really hurt yourself.
It's usually a credit event that lures the bear out of his den, though. It's rarely the first call that wakes it. In August 2007, two Bear Stearns-sponsored hedge funds specializing in leveraged bets on mortgages blew up. That was a huge warning sign, but three months later stock prices made all-time highs. Then Bear Stearns itself blew up, but the damage seemed to be controlled. Until Lehman blew up.
In 1997, the Asian currency crisis started. It took over a year to get to Russia, but then it defaulted and the markets fell 28% in a few weeks. Fortunately there was room to cut rates and the Fed had plenty of liquidity to offer (and Greenspan locked everyone in a room until they put up enough money to solve the problem). Less fortunately, we were in the tech bubble and the greed for soaring tech IPOs made all sins forgiven.
I don't know that Cyprus will default; I suspect a solution will be found, though it's possible its banking system collapses instead. They could come to regret the proposed haircut failure, which wouldn't have caused more than a wobble of a week or two, much like the demise of Bear Stearns. The problem is that, like a submarine that is too far under water, one can hear the stresses starting to creak the metal.
China is still trying to sort out its property bubble. If the books of all of its banks were truly open, I suspect we could get a crash tomorrow. I would be amongst the first to agree that stock markets can be very good at not looking at unpleasant things, and for longer than you think. The trouble is that not looking not only doesn't resolve the problem, it tends to make the eventual repair bill larger.
Europe is in a state of paralysis until either the German elections are over in the fall or some accident forces everyone into making hard decisions fast. That might not be so bad were it not for the fact that Greece, Spain, Portugal, Italy, France and Cyprus are all running on fumes. Cyprus might be small, as Fink and Bernanke said (the latter making me bow my head in despair - remember the subprime crisis being "well-contained?"), but add all those countries up and it isn't. Somewhere, sometime soon, a crack is going to appear in the financial system, and when it does equity prices will react violently. With the Fed already 99% extended, what will it be able to do?
Ask yourself the past results of asset prices soaring because of years of extreme central bank easing, then ask yourself again when it ended benevolently. The cruel irony is that the co-dependence on central banks by markets and politicians alike has prevented needed progress from being made on addressing economic imbalances. Mix the rot with price rises fueled by hyper-accommodation, and you get the scenario for a sudden collapse. There is no good reason for an economy with 2% real growth in a globe of steadily fading growth to be enjoying double-digit stock returns year after year, four years into a weak recovery - except that everyone else is doing it. Until they don't.
By all means, enjoy the fairy tale for a few more weeks if you can. I intend to. But when the S&P 500 crosses over to Never-Never land, I'll still be here, waving goodbye, wondering why we even had to go.
Disclosure: I am long SPY, SPLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.