There is a class of equities we call "cult stocks."
Roughly speaking, a cult stock is a high-growth concept stock, with an extraordinary degree of emotionally invested ownership. The classic cult stock typically has all of the following:
- An excellent story
- Excellent earnings / growth trends
- Leadership in its market space
- Membership in a "top 50 / top 100″ list
- Plenty of "blue sky" potential
When a stock has all the above, investors and money managers gain the courage to dream. With quarter after quarter of outperformance, optimism is entrenched as the feedback loop self-reinforces.
The naysayers are self-selected out (or carried out by losses on their shorts); the "truest" of true believers are rewarded with the biggest profits, by dint of their huge position size and/or willingness to "buy every dip."
The "in it for the long haul" longs are then free to paint visions of unlimited upside: Most every growth story has potential to grow yet bigger. There are always new markets to conquer… new ways the genius founder can revolutionize the industry / change the paradigm, blah blah blah.
For cult stocks, the earnings multiple thus has zero relevance. Whatever multiple exists - if there even is one - is justified in the rear view mirror, by way of the blue-sky-story du jour.
Eventually, expectations for XYZ cult stock become so ridiculous, they are literally impossible to fulfill. At this point, even a small miss - a minor disappointment, a modest whiff - can lead to complete and total carnage, as a crowded theatre of bulls (sans bears, who mostly left a long time ago) cry "FIRE!" simultaneously.
It is the way of all cult stocks. Expectations soar like Icarus, flying straight into the sun… until the wax wings melt and the share price goes into freefall.
Following Tuesday's earnings miss, the inflated expectations curse finally hit mighty Apple (AAPL). (Though AAPL is a strange hybrid - part cult stock, part cash-cow value stock - and as of this writing, with AAPL down circa 5%, true believers are still holding out hope for the iPhone 5).
In recent days the "Icarus moment" happened - to a far more severe degree - in the following sampling of names:
- Chipotle Mexican Grill (CMG)
- Whole Foods Market (WFM)
- Netflix (NFLX)
- TripAdvisor (TRIP)
- Buffalo Wild Wings (BWLD)
- Intuitive Surgical (ISRG)
- Akron Inc (AKRX)
- Questcor Pharma (QCOR)
- NVR Inc (NVR)
It is enough to make one wonder: What are growth stock investors thinking? Holding these names into earnings seems about as safe (and logical) as juggling live hand grenades.
Such has always happened, and always will happen, because human nature does not change - as the following quotes from Reminiscences of a Stock Operator, a book first published in 1923, make clear:
…The belief in miracles that all men cherish is born of immoderate indulgence in hope. There are people who go on hope sprees periodically and we all know the chronic hope drunkard that is held up before us as an exemplary optimist.
…When you read contemporary accounts of booms or panics the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game does not change and neither does human nature.
…At first, when I listened to the accounts of old-time deals and devices I used to think that people were more gullible in the 1860′s and 70′s than in the 1900′s. But I was sure to read in the newspapers that very day or the next something about the latest Ponzi or the bust-up of some bucketing broker and about the millions of sucker money gone to join the silent majority of vanished savings.
There are other, bigger financial cults, however - far more dangerous than the lemming hordes in overbought concept stocks.
The biggest of these is the Bernanke Cargo Cult.
In his 1974 Cal Tech commencement address, the brilliant physicist Richard Feynman warned against the dangers of "Cargo Cult Science." Read the following excerpt, keeping the Fed in mind as you do so:
I think the educational and psychological studies I mentioned are examples of what I would like to call cargo cult science. In the South Seas there is a cargo cult of people. During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now. So they've arranged to imitate things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas-he's the controller-and they wait for the airplanes to land. They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land.
~ Richard Feynman, Cal Tech Commencement Address 1974
I submit to you: Who is more patently ridiculous?
The South Sea Islanders, who at least have a lack of education as excuse for their folly?
Or the Federal Reserve, who is doing the exact same thing - the equivalent of coconut radio towers and what have you - in their persistent belief that lowering interest rates, or flooding the economy with useless liquidity, can somehow help unemployment in a deleveraging?
Here is a fresh example of embarrassing Fed folly:
Quaking in fear at the potential fallout from an AAPL earnings miss - which hit the tape at 4:30 EST on July 24th - the Fed followed up with a leak that same evening, via designated mouthpiece, Jon Hilsenrath.
The leak, er, WSJ story was titled "Fed Closer to Action," and contained the following money quotes:
Amid the recent wave of disappointing economic news, conversation inside the Fed has turned more intensely toward the questions of how and when to move. Central bank officials could take new steps at their meeting next week, July 31 and Aug. 1, though they might wait until their September meeting to accumulate more information on the pace of growth and job gains before deciding whether to act.
Fed officials could take some actions in combination or one after another. Fed Chairman Ben Bernanke, in testimony to Congress last week, listed several options under consideration, including a new program of buying mortgage-backed or Treasury securities, new commitments to keep short-term interest rates near zero beyond 2014 or an effort to push already-low benchmark short-term interest rates even lower.
Determined to keep trying to get the economy going without causing inflation, the Fed is exploring other novel measures.
~ Fed Closer to Action, WSJ
A more cynical bit of reporting might lead:
Completely freaked out by AAPL earnings, and the possibility their precious stock market might actually correct in the face of severe macro headwinds and unrealistic forward expectations, the panicked Fed decided to telegraph "Hey, we've got the juice" as quickly as possible… responding within hours of the AAPL miss…
And yet, in attempting to juice the economy, the Fed is forced to explore "other novel measures" - to use the Hilsenrath phrase - because NONE OF THE CURRENT MEASURES HAVE WORKED… and are arguably MAKING THE PROBLEM WORSE…
(By the way, for more on why the current Fed policy is not just ridiculous, but dangerous, you simply must read The Fed's Jelly Donut Policy by David Einhorn. If you have already read it, you know of what I speak.)
What yours truly would like to know is, why is the mainstream financial media not mocking the Fed?
Why is the mainstream financial media not visibly disgusted with the Fed?
Could it be because the Wall Street shill mechanism is utterly (and willfully) blind to the dangers of manufactured prices and manipulated markets, in spite of all the damage such has caused?
As Bernard Baruch observed,
Bulls always have been more popular than bears in this country because optimism is so strong a part of our heritage. Still, over-optimism is capable of doing more damage than pessimism since caution tends to be thrown aside.
And not just over-optimism, sadly, but flat-out flights of fancy and full-scale departures from reality that amount to reckless negligence in risk management terms.
The sad truth is, the Fed has gotten a pass because legions of short-sighted, long-only investors assume always-and-forever rising stock prices are an unalloyed good, no matter how that rise is created. These investors actually want a Bernanke Cargo Cult, in the hope it will serve their bias.
This Wall Street majority cheers their shaman-oracle-messiah, the Wizard of Zirp Bernanke, who can make stock prices rise with a wave of his magic QE wand.
And as for long-term consequences? Meh. Who cares about those…
Still, the amount of deference that Fed officials receive is mind-boggling. "Serious" financial journalists are respectful, because being disrespectful would cause a loss of precious political access.
But culturally sanctioned idiocy can reach a degree upon which, on the journalist's part, further respectfulness is not just a bad call but a gross dereliction of duty.
Consider the following from the Financial Times, one of the most respected newspapers on the planet:
In an interview with the Financial Times, John Williams, president of the San Francisco Fed, said that the weak outlook and the extent of downside risks "would argue for further action" but the counter-argument was doubts about tools such as QE3.
However, Fed officials are determined to ensure that the economy makes progress towards lower unemployment. In June, the rate-setting Federal Open Market Committee still forecast a decline in the unemployment rate over the next few years, albeit very slowly. Any downgrade to that forecast would be a likely trigger for further action.
"We are looking very carefully at the economy, trying to judge…whether or not the economy is likely to continue to make progress towards lower unemployment," said Ben Bernanke, the Fed chairman, in recent testimony to Congress. "If that does not occur, obviously we have to consider additional steps."
- Financial Times, Fed looks at third round of easing
What I want to know is, why are these men being taken seriously? Why is no one calling them out on the carpet?
- There is no evidence that past QE efforts have helped unemployment.
- There is no evidence that future QE efforts will help unemployment.
- There IS evidence - plenty - that the Fed's actions are causing distortions and damage.
If I were the FT journalist interviewing Fed Governor Williams, I would ask something like this:
Fed Governor Williams: Based on the available evidence, the idea that further easing will have any positive employment effect whatsoever is simply not credible. The Fed's collective track record has been terrible. Your rationales are terrible. In fact, with 30-year treasury bonds hitting record lows, your talking points (lowering rates further etc.) don't even make coherent sense.
In fact, Mr. Fed Governor, if you had sat here telling us the Fed wants to plunge billions into magic bean research, in the hopes of growing a beanstalk to the giant jobs castle in the sky, you would hardly have less credibility than you have right now. So why in the world should the Fed be given further leeway to pursue nonsensical monetary policies with 1) serious latent downside and 2) no genuine evidence that they work?
Mr. Fed Governor, a good definition of insanity, as you may have heard, is doing the same thing over and over and expecting a different result. So I have to ask: Are you people completely insane?
The problem, of course, is that it's all political… and politics has little to do with rationality or logic.
If the Fed were committed to logical, rational policies, they would heed Feynman's 1974 advice:
Now it behooves me, of course, to tell you what they're missing. But it would be just about as difficult to explain to the South Sea Islanders how they have to arrange things so that they get some wealth in their system. It is not something simple like telling them how to improve the shapes of the earphones. But there is one feature I notice that is generally missing in cargo cult science. That is the idea that we all hope you have learned in studying science in school-we never explicitly say what this is, but just hope that you catch on by all the examples of scientific investigation. It is interesting, therefore, to bring it out now and speak of it explicitly. It's a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty-a kind of leaning over backwards. For example, if you're doing an experiment, you should report everything that you think might make it invalid-not only what you think is right about it: other causes that could possibly explain your results; and things you thought of that you've eliminated by some other experiment, and how they worked-to make sure the other fellow can tell they have been eliminated.
Talk of scientific experiments is apropos because, in attempting to stimulate a deleveraged economy back to health, the Federal Reserve is conducting the biggest and most dangerous financial "experiment" of all time.
But are they doing anything that Feynman suggested?
- Are they committed to "integrity" and "utter honesty" in interpreting their monetary policy results?
- Are they reporting factors or findings that could falsify their stimulus theory (make it invalid)?
- Are they "bending over backwards" to the empirical testing aspect right?
No, of course not. They are doing the exact opposite of all those things.
Stubborn pursuit of the illogical, evidence-free notion that pushing down interest rates / propping up the stockmarket is pursued, doggedly and blindly, with no regard for logic, common sense, or experimental integrity whatsoever.
Simply put, the Federal Reserve is a ship of over-educated fools.
But you know what? It gets worse, because further evidence exists the Fed is a ship of morally bankrupt fools.
Consider the following data - most alarming if true, and close to the mark if exaggerated:
Seventy-five percent of Americans nearing retirement age in 2010 had less than $30,000 in their retirement accounts. The specter of downward mobility in retirement is a looming reality for both middle- and higher-income workers. Almost half of middle-class workers, 49 percent, will be poor or near poor in retirement, living on a food budget of about $5 a day.
- Our Ridiculous Approach to Retirement, New York Times
The ranks of America's poor are on track to climb to levels unseen in nearly half a century, erasing gains from the war on poverty in the 1960s amid a weak economy and fraying government safety net.
- US poverty on track to rise to highest since 1960s, Yahoo / AP
So let me get this straight:
- The Federal Reserve claims to care about the plight of the unemployed, even as reckless stimulus policies contribute to a higher cost of living (via upward pressure on commodities prices) while diminishing the value of savings accounts - meanwhile bearing little to no evidence of positive jobs impact at all.
- The Federal Reserve claims a stock market "wealth effect" is beneficial for the U.S. economy, even though 75% of retirement-age boomers - tens of millions of adult Americans - do not have enough savings to be meaningfully involved in the stock market at all.
It is a mantra of sound and sensible investing that short-term funds should not be put into stocks. If you need your money in a tight time-frame, e.g. less than three to five years, your exposure to near-term volatility is too high.
To have $30K or less, with retirement age looming, is practically the dictionary definition of "financially exposed." Such funds that exist should not go into stocks - for the vast majority of strapped boomer retirees, they should probably go into some form of super-safe savings account.
But what are such savings accounts yielding these days? Zip. Zilch. Nada. Thanks to the Federal Reserve. Worse still, the Federal Reserve is actively trying to "push" these boomers "out onto the risk curve"… where they have no business going whatsoever. It is almost criminal.
From a trading perspective, the current volatility is great. We can make money short as easily as long - and it is especially fun to see your equity curve going up, as the S&P turns down.
But from a citizen's perspective, the current environment is disgusting, appalling, and frightening.
As an individual in his thirties, and the co-founder of an intellectual-property-based business that can be relocated offshore fairly easily, I have to ask:
- For the boomer generation - essentially bankrupt via nil retirement savings - what happens when the severity of their retirement plight finally hits home?
- For the "Bernanke Cargo Cult" - administrators of the most shameful, dangerous and stupid financial experiment of all time - what happens when investors, and American citizens in general, lose faith in the coconut radio towers and promises that "the next easing will work?"
- For the US stock market - what happens if / when the US economy falls back into recession, stimulus or no stimulus, as corporate profit margins decline?
A word on corporate profit margins - the following chart is from Cullen Roche / Pragcap:
Prior to July 20th, stocks had not yet declined in earnest. This lack of decline, even as the macro environment deteriorated alarmingly, was due to a few things:
- Corporate profit margins were holding up
- The anticipation of QE3 put a psychological floor under the market
- "Presidential election year" arguments contributed at the margins
- "Top 30%" stocks - those catering to the upper middle class - looked strong
But now corporate profit margins are threatening to erode fast, as demonstrated by the "canary in the coal mine" of declining top line revenues.
What's more, as pointed out in this week's View From the Turret, fat profit margins and persistent unemployment trends are actually related:
- Many companies built and sustained fatter margins by driving harder bargains on wages and benefits. See the following, "At Caterpillar, Pressing Labor While Business Booms."
- At the same time, lower wages and benefits lead to steadily eroding revenues as discretionary income falls. Hence warnings from once-invincible juggernauts like Chipotle of same-store sales declines.
- Simultaneously, international revenues are contracting as the "pain in Spain" - and all of Europe - transmits to global exporters, and slowdown fears across the board. Note tell-tale misses from international bellwethers McDonald's (MCD) and United Parcel Service.
- Net result: Thanks to persistent revenue erosion, as US consumers retrench, China slows, and Europe spirals further into economic decline, unsustainable profit margins eventually give way. Which is pretty much what the current earnings season is telegraphing…
The Political Threat
To be blunt, I'm not sure which worries me more: The cack-handed idiocy of the Federal Reserve - whose policies are custom-crafted to exacerbate the wealth / poverty gap while making eventual outcomes worse - or the looming political backlash of a broke Boomer generation trained to extract entitlements from the voting booth.
Picture it: Fifty-million-plus boomers, broke as a joke… unable to land a job at Barnes & Noble or Starbucks (because too many fellow boomers have already applied)… contemplating a future of ramen noodles and efficiency apartment living.
To a political demagogue, that's fifty million votes to be held in the palm of one's hand…
There is an old prophecy that comes to mind, routinely attributed to Scottish historian Alexander Frasier Tytler.
Though the attribution is uncertain - many are certain Tytler did NOT say it - the vision painted is chilling, considering the disastrous policies being implemented… the retirement cliff that 75% of boomers are heading over… and the ravenous entitlement grabs yet to come:
A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world's greatest civilizations has been 200 years.
Great nations rise and fall. The people go from bondage to spiritual truth, to great courage, from courage to liberty, from liberty to abundance, from abundance to selfishness, from selfishness to complacency, from complacency to apathy, from apathy to dependence, from dependence back again to bondage.