In normal times, those evaluating equities focus mainly on company fundamentals, and for good reason. Investors monitor financial statements and assess company prospects in making investment decisions. The world we live in today is different, however. The current environment requires a much more macro oriented approach. The primary driving forces of credit markets increasingly revolves around major policy decisions against a backdrop of macro instability and uncertainty.
The credit system at least seems to be the largest dictator of asset movements in my view, with 'risk on' and 'risk off' waves serving as the structure of market dynamics over the last decade.
The macro signs at present indicate stocks could be entering a secular downtrend with 'risk off' mode creeping in, as I see, despite equity's recent outperformance. To get a better understanding, however, let's see why stocks have been outperforming in the first place.
Corporate Profits at All Time High
Companies are reportedly earning more than ever so market commentators have comfortably felt the last couple year's market recovery in equities is on solid footing:
What Could Be Wrong with Record Profits?
Profits are not always as they seem. What may be reported as today's grand profit could later be discovered to be less than originally thought or even a loss as unexpected costs arise.
The major way profits are overstated in relation to the business cycle is in undervaluing capital replacement costs. When companies acquire capital equipment they mark the expenditure on their financial statement accurately at the price they paid. What if in the next year the cost to replace that piece of equipment doubles, however? How does this impact their profit?
Until a new expenditure is realized the increased costs of maintaining or expanding business will not be factored in to on going profit reporting. Should investors not be concerned however that past 'profits' will need to be committed to rebuilding old infrastructure at multiple times its recorded cost?
The key fact here is during periods of inflation in producer equipment and materials, profits can be overstated and equities can be deeply overvalued. Is this characterization a proper reflection of the present environment however?
Well let's see what is happening to the cost of business equipment:
Producer prices are near all time highs and give light to the fact that over the last decade and half equities have largely been a series bubbles. These bubbles have driven equity prices up and down but produced no real returns for almost 20 years and no nominal returns for more than half of that:
A Final Technical Thought
As can be seen in the graph above, stocks represented by (NYSEARCA:SPY) or the S&P 500 index itself are showing a triple top. Three times over the S&P has failed to make clear highs and now we are either going to enter uncharted territory or head back down, possibly below the March 2009 low of 676 on the S&P 500. Leading indicators are starting to show signs that the next leg will be down and perhaps a strong one.
A Final Fundamental Thought
With the technical argument said, the last two major stock declines of the millennium were not accompanied by the Fed printing 10's of billions a week, and central banks around the world in full force as well, ready to act even further on a dime.
Despite these efforts we still have clear signs that deleveraging is underway so central banks are simply not covering the marginal requirements of the credit system it appears. If the Fed continues to operate behind the curve, lag in monetary policy transmission included, then markets are in for rough turn down now, just as they did in 2000 and 2007. I would suggest you look to prepare yourself before a possilble third strike.