Friday's poor employment report has significantly increased market macro risk from the first issue mentioned in my article last week titled “’Easy Money’ Is Over: 4 Issues to Focus on Now,” and this increased market macro risk is not linear, by which I simply mean that the market might go down a lot faster than it might go up, even if the technical trend is still up (e.g. index rising wedge patterns very close to breaking down).
That’s why the “’easy money’ is over,” this distribution of potential returns is not statistically “normal” right at the moment. I.e., at some point, it might not take too much more snow on the proverbial mountain to cause an avalanche. Before that might happen, Wall Street is strongly hoping that the upcoming 3Q reports, starting October 7 this week with Alcoa (AA), will produce well-scripted better-than-expected (BTE) earnings "beats" and guidance that quickly starts to alleviate that heightened macro risk.
The earnings part of the 3Q script seems likely, it's the guidance that will be key. Why is the corporate insider sell-buy ratio still so high if corp exec's really believe that equity prices haven't gotten ahead of visibility on the recovery.
A Recovery in Fits and Starts, or Scripted Better-Than-Expected 3Q Earnings?
Wall Street reluctantly acknowledges the setback of Friday’s very poor employment data, which followed a series of worse-than-expected (WTE) economic reports (one of the latest being poor retail sales in W. Germany). It chooses to interpret these as expected.
For example, as a sign that the recovery will proceed in fits and starts, mainly starts, and the ensuing expansion will be quite tepid by historical standards (though 2010 global economic growth estimates are still being raised to 3-4%). But most importantly, one with corporate earnings growth robust enough ($75 for S&P in 2010) to justify “normal” valuations (e.g. p/e around 15 or higher). That combination of subpar revenue growth and decent earnings of course depends on corporate margins reaching high levels quickly, then justifying even higher valuations.
(Similarly, the “second derivative” of ECRI’s Weekly Leading Index (WLI), which has been my only highest rated “key market factor,” made a secondary peak August 21, the first being Jun 19, when SPX topped a week earlier.)
And Wall Street certainly realizes the potential negative economic implications of lower long-term interest rates and the recently flattening U.S. yield curve, and the very risky game of a weakening dollar being used for carry trades.
Will Market Rally Transition from Seeking Beta to Seeking Alpha?
Yet what Wall Street of course won’t acknowledge is that, given what the market has come to price in with the huge post-March 9 rally, it is now possible that the market may go down much more quickly than it expects it to go up.
Rather, Wall Street hopes that the market is now going through a typical change from the seeking beta to seeking alpha stage of a rally, which at worse will be a brief period of uncertainty.
In the first “easy money” seeking beta stage, which is now over, all the more risky global assets (e.g. junk bonds, emerging markets, small cap stocks, some financial stocks, etc) have indiscriminately gone up a huge amount.
Wall Street now hopes that in the next seeking alpha stage, the market will supposedly start to better differentiate between the true economic winners and losers, be it entire asset classes or individual securities. This is where true investment skill is supposed to come in.
With respect to one of the strongest asset classes, emerging market equities, Wall Street believes that the central banks' tightening cyclec will start there first, and this might trigger a modest correction in those markets. The key countries to watch in 4Q are probably S. Korea, which might tighten 25 bp, and China, which may raise bank reserve ratios (having already ordered much slower bank loan growth starting in July); and India in 1Q next year. S. Korea’s Kospi index, which has been been extremely strong, tends to be a good global leading indicator. Wall Street is hoping that if tightening were to proceed in this way, it would not have the effect of also unduly causing concern over the Fed's exit strategy from its unprecedented easing. Rather, it hopes that following the 3Q earnings report scenario described above, that there will then follow a typical well-scripted seasonally strong year-end rally, which the bail-outees would then celebrate with huge bonuses, with the Fed's exit strategy and everything else swept under the rug until 2010, after those outsized bonus checks are safely deposited (btw, the old normal).
Can the Economy Learn How to Multiply?
In recent articles, Kass, Xie, and Whitney talk about one reason why things might not turn out the way Wall Street hopes, due to the lack of multiplier effects in this recovery.
Whitney’s widely cited Oct 1 WSJ op-ed starts off:
Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting. Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan.
How long a bubble lasts depends on the size of its multiplier effect on the economy... Only a multiplier effect from the current bubble is stopping financial institutions from going under. However, weighed down by trillions of dollars in non-performing assets, they cannot lend with abandon again, which makes it impossible to revive property bubbles.
The stimulus spending proposals above, particularly in their current form, don't have a meaningful multiplier effect but, more importantly, borrow from future sales of automobiles, housing and, generally speaking, retail sales.
Follow Trends, Watch for Early Signs of Change
I only have been contributing to Seeking Alpha since late July. I try to follow the major trends, trying to look for early signs of increasing risks of a trend change. For example, I downgraded China as one my two highest rated “key market factors” in my July 31 article, a few days before the Shanghai index peaked on August 4.
There was an early sign that the “easy money” bet simply on a recovery was over when the market reversed on September 23, “even though the Fed once again had tried to assure the market that its exit strategy from its unprecedented easing would be quite gradual” (from my September 28 article the “”Easy Money’ Is Over”).
Unlike bubblevision permabulls, I have noted, since my August 31 article on “Factors Most Likely to Cause a Market Top,” the increasing risks to the post-March 9 huge rally. Unlike Internet permabears, I also have consistently acknowledged the strength of that rally.
I feel that double-sided approach has been appropriate right now, at this stage of the cycle. It would be a lot easier if it wasn’t, but as I said, the “easy money” is over, for now. Day Traders vs. Trading Bots Finally, a brief comment from Alan Farley from Realmoney.com's "Columnist Conversation" on Friday. Farley, who wrote a 2000 book on swing trading and has been commenting on that site a long time, says that in the course of writing a new book scheduled for next March, he realized that:
"The influence of the trading bots decreases as a function of time in the market. In other words, they have near monopolistic power on the short-term tape, moderate influence on the intermediate tape, and practically no influence on the long-term tape.So, from my viewpoint at least, the machines are strictly a trader's issue, and investors should just keep on doing what investors do."
Source: ECRI.
