What a difference a few data points can make.
A few trading sessions ago, the market was following a “global goldilocks” narrative:
- The European sovereign debt crisis appeared contained.
- Europe had unleashed its own version of “QE3″ (aka “LTRO”).
- The U.S. economy saw falling jobless rates and respectable growth.
- Corporate profit margins appeared robust, making stocks look “cheap.”
- The big emerging market players — China mainly — were chugging along.
Then, in the space of a week, a series of jarring “wake-up calls” came along, leading to the market’s worst dive in months (and bloodiest day of the year thus far).
To set the stage, Fed Chairman Bernanke threw cold water on the prospect of further quantitative easing (QE) last week. Hints of “no more stimulus” led to a brutal one day 5% drop in gold, and introduced a new and worrisome thought into investor’s minds: If the economy is really healing on its own, the Fed could withdraw its helping hand.
Wall Street is hopelessly addicted to cheap money flows. And thus, ever since the global financial crisis, the perpetually weakened state of the U.S. economy has been a blessing in disguise for paper assets. In an effort to keep the broader economy from keeling over, the Fed has been pumping liquidity into the patient.
But now, as the state of the U.S. economy goes from “bad” to “less bad,” the addict (Wall Street) has to face the challenges of withdrawal.
Dallas Fed President Richard Fisher has referred to this as “monetary morphine,” adding in a recent speech:
I would suggest to you that, if the data continue to improve, however gradually, the markets should begin preparing themselves for the good Dr. Fed to wean them from their dependency rather than administer further dosage…
I am personally perplexed by the continued preoccupation, bordering upon fetish, that Wall Street exhibits regarding the potential for further monetary accommodation — the so-called QE3, or third round of quantitative easing.
“But hold on,” the bulls say.
“Stimulus withdrawal may be a problem for precious metals and other speculative inflation plays, but what about corporate profits? Based on historical earnings measures, stocks are cheap!”
In fact, equity valuations are at a 23-year low by some optimistic measures:
Corporate profits that doubled since 2009 have left the Standard & Poor’s 500 Index cheaper than at all 34 peaks since 1989, even as options traders push the cost of protecting against losses to the highest in four years.
Companies in the benchmark gauge of U.S. stocks trade for 14.1 times earnings after advancing 102 percent since March 2009 to an almost four-year high last week, data compiled by Bloomberg show. Valuations are lower than at every 52-week peak since 1989.
Hmm. Can you spot the problem with this logic?
Hint: It’s the same logic that argues Apple (AAPL) is on its way to a trillion dollar market cap. Such an outcome is technically possible… but would have to be filed under miraculous.
Trees don’t grow to the sky… and neither do profit margins.
The reason that Apple has reached a $500 billion valuation — besides the relentless genius of Steve Jobs and his team — is the astronomically high profit margins the company has managed to achieve.
Via Martin Hutchinson, Apple boasted a 37.7% sales margin and 91.3% return on equity in Q411. That type of performance is impossible to maintain, especially for a $500 billion company operating in one of the most competitive market environments in the world.
To put it another way: If Apple’s profit margins are not brought back to earth through fierce competition — including competition with itself, as owners of current generation iPads and iPhones choose not to upgrade — then capitalism is broken.
And the same thing goes for the lofty profit margins of the entire S&P 500 in this post-2009 environment. Stocks are “cheap” measured against record earnings, or compared to the rubber yardstick of government bonds yielding next to nothing.
But when one considers the mean-reverting nature of profit margins as a natural function of capitalism, coupled with the threat of stimulus withdrawal and a less accommodative Fed, the bull case is on shaky ground.
This week’s real carnage, though, was brought on via emerging markets…
China shocked markets this week by lowering its official growth target for the first time in seven years. While the target is mostly symbolic, it functions as a sort of telegraph for the policy stance of the Chinese government:
By lowering China’s growth target to 7.5% this year, Premier Wen Jiabao has signaled that an era of supercharged expansion may be coming to an end, a shift with profound implications for countries like Australia and Brazil that have prospered from red-hot Chinese demand for commodities.
The adjustment suggests that China’s leaders have reached a comfort level with slower growth, and that they don’t intend to stimulate the economy through state-led investment, as they have in the past. Instead, they plan to let a long-touted shift away from export-led expansion take its course…
Fallout from a “China slowdown” scenario will certainly hit the Australian dollar, which has long been bid up in concert with 1) Australia’s strong resource-driven economy and 2) China’s resource-hungry appetite.
That feedback loop could unwind rather rapidly in coming weeks and months, especially as speculative capital withdraws from the resource space.
At is it turns out, China’s hint at slowdown was only the first of a one-two punch emerging market combo. Brazil added to woes by reporting its second-worst annual performance since 2003, due to higher borrowing costs and a currency at 12-year highs.
And then, as the piece de resistance, some more unsettling news from Europe:
Along with ongoing Greece jitters, Spain has decided to embrace fiscal mutiny, giving taskmaster Germany the finger. As Ambrose Evans Pritchard writes:
The Spanish rebellion has begun, sooner and more dramatically than I expected.
As many readers will already have seen, Premier Mariano Rajoy has refused point blank to comply with the austerity demands of the European Commission and the European Council (hijacked by Merkozy).
Taking what he called a “sovereign decision”, he simply announced that he intends to ignore the EU deficit target of 4.4pc of GDP for this year, setting his own target of 5.8pc instead (down from 8.5pc in 2011).
In the twenty years or so that I have been following EU affairs closely, I cannot remember such a bold and open act of defiance by any state. Usually such matters are fudged. Countries stretch the line, but do not actually cross it.
With condign symbolism, Mr Rajoy dropped his bombshell in Brussels after the EU summit, without first notifying the commission or fellow EU leaders. Indeed, he seemed to relish the fact that he was tearing up the rule book and disavowing the whole EU machinery of budgetary control…
- Ambrose Evans Pritchard, Spain’s Sovereign Thunderclap and the End of Merkel’s Europe
The debate has always been as to what the struggling periphery countries (aka PIIGS) will ultimately do. Will they endure slow economic agony by way of forced German austerity? Or will they quit the euro entirely, creating chaos on the way out?
Now we are seeing a third possibility — open defiance, with the strapped PIIGS in effect saying “Screw you Germany (and Brussels)… we’ll do whatever we have to.”
In short, Europe’s internal fiscal crisis is moving to the point where words no longer matter, and baseball bats are being laid out on the table.
Add in the prospect of rising U.S. rates if the Fed continues to hold back on bond purchases — who’d have thought a falling jobless rate would become the enemy of the stock market? — and this could all get very ugly, very fast.