As I wrote last Thursday, Mario Draghi's "believe me" speech was a desperate, all-talk attempt at restoring market confidence.
It was also dangerous.
The speech, which was followed by unsourced rumors from Bloomberg stating that Draghi is a proponent of peripheral bond purchases, further props up global markets as they price in direct purchases of peripheral debt. This (mistakenly) puts risk-buying back on the table, and reduces short-term volatility indicators to complacent levels.
Over the weekend, the German Financial Minister said that there is "no truth" to the rumors, and Spain paying a couple hundred extra basis points for funding "is not the end of the world."
The only thing the market cares to think about right now is this Wednesday's FOMC statement, but Thursday's ECB press conference could take a little risk back off if the bond purchasing program is not reinstated.
The Big Picture
As this crisis drags on, private sector deleveraging will continue and markets will continue to discount the risk factors on a long-term basis. Even with most of the EU in moderate to severe recessions, most stock markets have remained strong even without desperate attempts from central bankers to restore confidence.
U.S. companies have performed sufficiently well in 2Q, with about 4.5% YOY growth (closer to 2% ex-financials). However, markets appear to be pricing in far too much forward earnings growth, considering the 12% 2013 EPS growth estimates.
These estimates are predicated on the idea that the EU will "recover," when economic reality is displaying that the EU as a whole will likely continue to slowly deteriorate before bottoming out as a result of major restructurings.
As this artificially prolonged bottoming process occurs, U.S. companies will continue to see their earnings negatively affected in a controlled manner. With domestic growth slowing to 1.5%, and trending downwards, it won't be long before corporate earnings growth is flat to only marginally positive. As I wrote recently in my long-term outlook for stock returns, this kind of earnings growth is typical in a post-credit bubble environment.
The overall conclusion for the long-term is that the powerful, global deleveraging (deflationary) forces are in their infancy, but market prices reflect their conclusion by the end of 2012.
Stocks Are Very Expensive On A Short-Term Risk Basis
The early June lows on the S&P 500 (SPY) around 1,280 mark an important point, since that is where central intervention placed a put on global markets (Spanish bank bailout speculation, QE speculation, etc.).
Also of major importance is the 1,340 level, which is where the market has formed several tops in the aftermath of the Spanish bailout, Greek elections, and the EU Summit.
The following chart from ZeroHedge shows this price action (S&P price is not current):
Since then, the S&P has rallied another 45 points to 1,385, which is about 13.5 times the cumulative estimated earnings for the S&P 500 ($104).
With stocks already priced at 13.5x estimated earnings, upside is extremely limited, especially when we consider the trend of downward revisions, and the obscurely high fourth quarter estimates that have yet to align with likely reality: 16% EPS growth, including an outrageous 97% growth projection in the materials sector.
Market sentiment now indicates that the following factors are priced in:
- ECB bond purchases of peripheral debt
- Q4 S&P earnings growth of 16%
With Germany quietly stating that there is "no truth" to the purchases, it's hard to see how markets will remain stabilized as Spain and Italy go to the bond markets for nearly 200 billion euros, collectively, in the remaining months of 2012.
Upside in the SPY looks to be very limited. QE3 is highly unlikely to be initiated this Wednesday, considering equities are only 2.5% off their highs, and commodity prices are still strong. Talk of ECB bond purchases appear to be unsubstantiated rumor, and Q4 earnings estimates have yet to align with reality.
With valuations nearing the upper-end of their range and EPS growth slowing, the fundamentals show stocks likely treading water for the year, ending a few percentage points lower than today's 1,385.
As for the short-term, markets remain seriously complacent to near-term risks, and as has been the case with all EU interventions, are likely to fall as the "rescue" plans don't work out as planned.