- The level of fantasy in the stock market is directly proportional to the relative price level.
- The chronology of a mature bull market correction.
- Some facts and fantasy comparisons in the current stock market.
The levels of fantasy in the world of money are ratcheting up a little more every week. If history is any guide, if human behavior retains its constancy, we can expect two events to follow in the stock market. The first event will be a "sudden" correction, one that usually comes some number of weeks, typically around six to twelve, after the onset of prominent names starting to worry about such a correction.
The logic of such a course of events is relatively simple and will appear to be glaringly obvious in hindsight, but almost completely obscured in prologue, partly by the noise of the crowd and partly by the unrelenting pressure generated by those upward sloping price charts - pressure to believe what the crowd believes, pressure to generate a narrative that justifies today's prices, pressure not to be left behind, pressure to be one of the clever ones.
I promise to come to the fantasy later, right now I want to stick to the anatomy of the first correction. They tend to come in the summer, and for good reason - the first quarter is nearly always up, April is one of the best months of the year for stock prices, and aging bull markets develop a distinct trend of preying on early announcements of its demise. The late stages of an economic expansion are always accompanied by predictions of a second leg of growth that will make the current cycle different from all the others. Come spring, valuations start to appear toppy and expensive for the same reasons every time - prices keep rising but that extra growth leg is not materializing.
When a bull market is truly mature, stock prices make the switch from rallying on genuinely good news - increasing growth rates in corporate earnings, principally - to rallying on the failure of storm clouds to become hurricanes. Every time we don't go to war, every time the market doesn't sell off in the first week of May or September, every time the Fed doesn't raise rates - these are excuses to rally, because they seem to justify the status quo. Though I don't think it an industry-wide phenomenon or believe in the global cabal (admittedly crossing my fingers on that one at times), I have long believed that certain kinds of warnings coming from prominent places at these stages in the market are quite simply staged. Yes, yes, I know - you are shocked to find gambling going on in this establishment.
Consider the almost completely bizarre outburst of hints and warnings in the last week or two that the FOMC might spring an early rate hike at the June meeting. There was not the vaguest of hints from anyone at the Federal Reserve that the bank's governors had suddenly been replaced by look-alike aliens with a different agenda. Or that Janet Yellen, the most dovish Federal Reserve chair in about forty years, would suddenly think it a good idea to stun financial systems around the globe by tasering them with a surprise rate increase. Yet the rumor soared in currency like Bitcoin in the week leading up to the Fed's statement. Surprise, surprise, the Fed did not raise rates, and the stock market rallied. I might ask who was kidding whom, but I have seen this kind of thing happen so many times over the decades that I don't even raise an eyebrow anymore.
I don't want to digress any further, so let's come back to the correction chronology of the aging bull. As it moves to new highs in the spring at the same time corporate earnings growth is slowing or even declining, some prominent names will start to voice anxiety. Familiar ghosts come back from the past: Long-term, broad indicators like Tobin's Q or the ratio of market capitalization to GDP will be noted as being at alarming levels even as the economy is failing to deliver on its promises (or rather, the stock market's promises).
But bull markets don't correct simply because someone says prices are too high (or reverse because someone notices that valuations are too low). The degree of high or even outrageously high valuations is never what makes markets correct - it's what decides how much they will correct (or eventually, crash). Granted that as valuations become more extreme in either direction, so grows the vulnerability to an abrupt about-face, but the mere facts of price, valuation, financial logic or even vulnerability are never the catalysts. Look at Amazon's (NASDAQ:AMZN) stock price.
Markets reverse on the unexpected. So the first real correction in the aging bull market comes after it has apparently dispatched its enemies. The worries begin in the spring, but markets never, ever crash in the spring. Stock prices often begin to correct in late April, usually because earnings have failed to live up to promises, but how much they correct will depend on how much they ran up beforehand. In March of 2000, the answer was a whole lot of crazy: Result, prices began falling in May. In April of 2014, it was a whole lot of nothing. Result: prices rallied in May.
In June of 2007, the market completed a near-15% rally from its March low, What "sell in May?" What credit bubble? Here are some sentiments from May of 2007 that I wrote up at the time - they should seem familiar to you. First, from a floor trader: "I don't know that the economic data matter that much. There's so much liquidity in the market, I think we can get by any of it." Another trader told CNBC that come what may, Chairman Bernanke would do the right thing. When pressed as to what that might be, she replied," I don't know what he'll do, but I'm sure he will do the right thing." I also wrote that price rises in the face of dangers give rise to the belief that the market can triumph over anything, and that "faith in a market takes on the overtones of a religious credo."
So it wasn't in the middle of last month that we were likely to correct, when everyone was worried about it and short interest at a multi-year high. Not that it was impossible - had Russia invaded Poland, even Jack Bouroudjian might have sold equities - but it didn't, and he didn't. No, first the market must seem to dispatch all of its potential enemies. After all are convinced of the unstoppable upward momentum, then we can stumble - and the higher the step, the more painful the slip. We're close to that point now. A day or two of follow-on like yesterday and we'll get there, though trying to nail it to that short a period is always tricky.
The precursor correction to the 2000 crash started at the end of July 1998 after prices made a new high in June. In 2007, the sequence was new highs in May, new highs in June, thud in July-August. In both cases, the markets later went on to new highs. In both cases, there was a growing sense of belief that bordered on the fantastic and resided in invincibility, in the very inevitability of the stock market.
As promised, here are some recent examples of fantasy: In the latest edition of Barron's Trader column, Citigroup (NYSE:C) equity strategist (and notorious Pangloss) Tobias Levkovich notes that corporate earnings "were surprisingly strong in the first quarter, growing about 5%." Excuse me? I don't know what machinations Mr. Levkovich must have pulled off to arrive at some variant of "operating earnings" to justify that claim (I am perfectly capable of pulling off the same), but such nuances were not disclosed, only the blanket statement that corporate earnings grew at 5%. According to FactSet, S&P 500 earnings grew at 2.1% in the first quarter. According to the Bureau of Economic Analysis, profits decreased: domestic profits from financial companies decreased $71 billion, from non-financial companies by $102 billion, and rest-of-world profits were down $40 billion.
Then along comes Fidelity's Julien Timmer, who blithely tells us that with earnings growing at 7% this year, add in 2% for dividends and well, you've got the stock market up another 10% or so. Never mind what the multiple should be for 7% growth or 2% yield, the 7% is only an estimate (wasn't it 10% back in December?). Yet corporate earnings are currently estimated at 5.4% for the second quarter, a number that will probably drop to 4% (at best) in a few weeks. The third and fourth quarters, just like every year at this time since 2010, are estimated to grow at double digits. They never do, but they'll have to if they are going to get to 7%.
The annual fantasy is that earnings will do it, despite another fact: Within the last week, the IMF, the World Bank, and the Federal Reserve all cut their GDP forecasts for the US this year to a range of 2%-2.3%. One thing I can tell you about all three of them is that they don't lowball their US estimates. Notwithstanding, the S&P 500 rode to a new high, because you know, Janet Yellen will do the right thing, whatever that is. After all, didn't she say that the stock market isn't in a bubble? Never mind that even the janitor at the Federal Reserve knows perfectly well that the first Fed Chairperson to ever say that the stock market is way too high would a) cause a global financial panic b) be taken out and shot. "After all, there's so much liquidity in the market it doesn't matter."
Bear market this year? Not likely. Recession? Probably not. New highs? I think so. Correction? Yeah, you betcha.
Additional disclosure: I have stock market hedge positions.