Faith in the Markets? It's All in the Numbers

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Includes: DDM, DIA, QID, QQQ, SDS, SPY, SSO
by: Scott Harris

September will be a bad month. Why? Because history has shown that it is. 1040 on the S&P is a strong support point – likely the bottom. Why? Because history has shown it to be. An average P/E ratio below 18 for the S&P 500 is a buy. Why? Because over the past few decades anything below that is "cheap".

In all my years investing, I am hearing more about "charts" and "technicals" as reasons to buy than any other reason. This is of great concern to me. Just because 1040 is "support" for the S&P does not, in any way, make it a time to buy stocks without the underlying fundamentals to back that number.

When the economy is growing, homes are selling, consumers are buying, and businesses are reporting both revenue and earnings growth each quarter it is easy to explain why stocks move in an upward direction. When consumers aren't buying, homes aren't selling, and businesses are reporting lackluster earnings growth and shrinking revenue, it requires a certain amount of faith that "the economy is recovering" or "is going to recover" to continue to buy stocks. And there are plenty of people out there preaching that such faith is justified. Unfortunately their religion lacks fundamentals to back it up.

There are three trends that are particularly concerning to me. The first are analysts' estimates and the response from investors when earnings beat those estimates. Without picking on a single stock, let's take company XYZ (you can find many analogs once you read the rest of the scenario). Analysts expect XYZ to post earnings of 10 cents a share this quarter, which is 20% below the same quarter last year when the stock was at $10 a share. Over the past year the stock has risen to $22 a share, and when it beats "estimates" at 12 cents a share the stock flies up another $2 to $24 a share. Yes we beat "estimates" by 20%, but estimates were 20% below where they were a year ago when the stock was trading at $10, so why didn't the stock go down to $8.40? Even if the earnings had been 50% better than last year's numbers, why isn't the stock trading at $15 rather than $24? Yes, you can argue that last year was all doom and gloom and now we are looking at recovery, but what kind of recovery? To justify the $24 stock price we need to see an additional recovery of more than 50% over the next year. No matter how optimistic investors may be, we are not going to see anything like the kind of recovery that occurred from 2003-2007.

The reason for this is simple. The recovery from '03-'07 was due to extremely lax credit and artificially inflated home values (largely due to lax credit). America simply bought far more than it could afford and will be paying the price for that for many years to come. College kids with no jobs were getting credit cards and buying 50" plasma TVs and new wardrobes. Things have changed and now servicing that debt has become an overwhelming burden. The days of easy credit and lack of fiscal responsibility are gone and not coming back any time soon. Consumer spending is not by any means dead, people still have to buy stuff, but the days of excess are finished for now. Businesses no longer have the customers necessary to grow their revenue by 30-40% a year.

Stocks may have been "cheap" a year ago, but there is little reason for them to have risen as much as they have since that time.

The second trend that is concerning is how the government is reporting numbers. Since the beginning of this year I noticed an increasing trend of the government reporting numbers that are "better" and then revising them unfavorably in later reports. The markets tend to move with the most current number, and in some cases rallying on a "growth" of this number based on a negative revision of the previous number's revision.

A perfect example of this (although not nearly as heinous as some of the other revisions) was Wednesday's jobless claims number. It was reported that jobless claims dropped by 6,000 to only 472,000. This was "great" news. It dropped by 6,000 and it was better than the 475,000 estimate. First off, the 6,000 number is rather dubious as the number last week was 475,000, which would mean that this week's number was only 3,000 better, but since last week's number was revised to the worse to 478,000, they used that number in reporting how much better the jobless number was. Second off was that the market only responded to the "better than estimates" number, completely disregarding the fact that last week's number was actually worse than reported. Seemingly completely ignored is the fact that 472,000 new jobless claims is a horrible number and not a number that points at a sustainable recovery.

The final and most concerning trend is the simple use of numbers and statistics to argue for the purchase of stocks. We are in a period where no underlying fundamentals (such as economic growth, a growing customer base, a customer base whose discretionary spending is growing, etc.) suggest overall revenue expansion or profit growth for corporations should be cause to pay a premium for stocks. The old saying "statistics never lie, but liars use statistics" may end up proving itself true once again. There is absolutely no question that the market bounces and dips due to support and resistance points, but why? And which way will it end up after so many attempts to break these resistance and support points? S&P 1040 is a "critical" number – ask any chartist and they will tell you. But when you stop to think about it, the S&P index number is made up of the prices of 500 different stocks. Other than an almost religious "faith" how can that particular number be at all relevant?

Reality ceases to matter at that point. Stocks will bounce at 1040 and have many times before. Will they next time? Maybe. But, again, for no reason other than the current religious faith that exists in the numbers of the stock market.

For centuries the world was flat because religion said so. Even after proven otherwise, reality didn't matter, religion prevailed until such pretense was no longer possible. In reality the markets should be much lower than they are, but the religion of the markets and the preachers who sing its praises still reign. This too will prevail until the curtain is raised. And when that happens, you need to be prepared as the transition from faith to reality will be swift and ugly (hate to say it since this article is all against using historical analysis as a guide, but history shows this!)

Most people are familiar with the fairly recent phrase "extend and pretend". Few understand that it applies to more than just home mortgages. There are a whole lot of very powerful entities who stand to lose a lot if or when reality sets in including our government, pension funds, insurance companies, banks, and others. Arguments can be made that such powerful entities will not allow our economy and markets to fail, but if the world is not flat, the truth will eventually come out. Protect yourself.

Disclosure: Long SDS