"The market can stay irrational longer than you can stay solvent." John Maynard Keynes.
That observation was made by Keynes in the 1920's at a time when his margin account had been wiped out trading currencies. He is generally thought of as a brilliant theorist but Keynes was also a trader of some significant repute. What Keynes discovered was that his extraordinary talent for fundamental analysis did not assure him a profit in the markets.
Keynes' statement always comes to mind during periods of irrational euphoria. The stock market is an elegant pricing mechanism that always gets it right eventually but much like an airplane, it is constantly veering off course. The pilot's job is to make slight adjustments to the plane's heading to compensate for wind effect. A pilot who is not paying attention will veer way off course. When he corrects his heading he may very well compensate too much and end up veering way off course in the opposite direction.
Markets are similar in that they too veer off course. Most of the time market movement away from price equilibrium is not significant and the corrections are modest as well. When irrational euphoria or irrational pessimism sets in the markets can extend substantially above or below equilibrium.
Please Give Us Another Dose of QE
There is one significant wind effect that's moved the markets in recent weeks - the almost manic expectation of central bank action to expand money supply. Traders are driving prices higher because they see QE3 as a cure all that will negate all the headwinds we are encountering. No trader will argue the point that the markets in recent weeks have reverted back to a "bad is good" mindset that has driven the markets ever since the Fed started quantitative easing in 2008.
The general consensus among analysts, economists and traders is that QE3 will not have a significant impact on the economy. On the other hand, it is hard to find anyone within that group that doesn't think QE3 will boost stock prices. Bernanke even noted as much in his recent Jackson Hole speech last week:
"LSAP's also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases." Ben Bernanke - Jackson Hole, WY speech August 31, 2012.
Bernanke seems unconcerned with the fact that the fuel driving the market today is Fed policy and perhaps he is even a little pleased that at least some part of the economy is responding to his efforts. Bernanke can't take credit for the broad based rally in the markets yesterday though. Credit for that goes to his counterpart at the ECB.
Yesterday's market response to the announcement that Draghi made on the ECB's plans to buy short term sovereign bonds was dramatic but a little disconcerting. Draghi made the announcement well ahead of the U.S. market open and traders flooded the market with "buy on the open" market orders. Market makers on the other side of these trades immediately started taking protection by raising the "ask price", the result being a 160 point gain in the first 10 minutes.
So back to Keynes and his point on irrational price movement - it is hard to make sense out of these market orders yesterday. One can only assume that traders were certain that the market was going to get away from them in a rapid ascent higher and they would miss the next major leg up if they didn't just close their eyes and buy at market.
The market moved another 80 points on low volume as market makers continued to raise the "ask" price at which point volume died and the market remained flat for the balance of the day. What is most confusing though is that the market made a 2% move higher on old news. We've known for days that the ECB was going to start a sterilized bond buying program. Draghi offered nothing new today except his decision to remain pat on interest rates.
Do you remember the lyrics from an old Ricky Nelson song - "fools rush in where wise men fear to tread"? Those lyrics seem particularly appropriate today. As a fundamental analyst who pores over data constantly, it is hard to see the rationale in this manic fascination with QE3. The risk/reward on stocks as a broad asset class is terrible in light of existing headwinds:
- Debt to GDP over 100%.
- Unemployment at 8.3%.
- Recession in Europe.
- Growth slowdown in China.
- Shrinking revenues.
- Lowered earnings forecasts.
The list is long and the truth is everyone knows these headwinds are out there. In his Jackson Hole speech Bernanke readily acknowledges this fact:
"I see growth being held back by a number of headwinds. First, although the housing sector has shown some signs of improvement, housing activity remains at low levels and is contributing much less to the recovery than would normally be expected at this stage of the cycle.
Second, fiscal policy, at both the federal and state levels, has become an important headwind to the pace of economy growth. Notwithstanding some recent improvement in tax revenues, state and local governments still face tight budget situations and continue to cut real spending and employment. Real purchases are also declining at the federal level. Uncertainties about fiscal policy, notably about the resolution of the so-called fiscal cliff and the lifting of the debt ceiling are probably also restraining activity, although the magnitudes of these effects are hard to judge.
Third, stresses in credit and financial markets continue to restrain the economy. Earlier in the recovery, limited credit availability was an important factor holding back growth, and tight borrowing conditions for some potential homebuyers and small businesses remain a problem today. More recently, however, a major source of financial strains has been uncertainty about developments in Europe." Bernanke speech at Jackson Hole, August 31, 2012.
In light of these headwinds that almost everyone who participates in the markets realize, the market remains resistant to their impact on growth and earnings preferring to bank on QE3 as some kind of magic elixir that makes everything OK. It would be easy enough to accuse Bernanke of creating a quantitative easing bubble if it weren't for his forthright honesty about the impact of additional easing:
"Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain and the use of nontraditional policies involves costs beyond those generally associated with non-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally. Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly can't fine tune economic outcomes." Bernanke speech at Jackson Hole, August 31, 2012.
The "fiscal cliff" is a serious impediment to growth. Relatively speaking the matter gets very little play but it is a serious problem that the Congressional Budget Office says will result in a recession in 2013. Most everyone shrugs off the "fiscal cliff" issue assuming that we will deal with it after the election. That is an interesting perspective and another case of an irrational response. How exactly will we deal with it? There is no resolution to the "fiscal cliff" issues that end in a positive outcome. Consequently we just shrug it off and bet on Bernanke to give us our QE fix. The CBO sees 2 scenarios.
The first scenario is that we do go over the "fiscal cliff" and fail to extend the tax cuts and implement spending cuts - the result being a GDP contraction ending up in a recession in 2013. Unemployment moves back up to 9% under this scenario. Based on Congressional inaction it is a virtual certainty that this is the scenario that will occur.
The second scenario is that we continue to fund entitlements through deficit spending and continue to grow the federal debt. The CBO says that such a course, although in the short term resulting in a better outcome, after 2013 it will be unsustainable.
Everyone tends to weigh in on the "fiscal cliff" issue with what they see as the right way to get the country growing and on the right track. The reality is that no one knows how to deal with our problems - at least in a way that ends positively. Flat GDP growth and persistently resistant unemployment continue. We have used all the tools in our tool kit and we haven't fixed the problem.
There has been some debate of late on whether or not our unemployment problems might be structural in nature and therefore not responsive to monetary or fiscal policy. Bernanke weighed in on the subject in his Jackson Hole speech but concluded that he didn't think structural damage was the reason unemployment numbers persist at high levels. The evidence suggests otherwise and was addressed in my recent article, High Unemployment - The New Economic Paradigm.
Whether persistently high unemployment is the result of structural damage or not, it is not being resolved and it poses a huge problem for GDP growth going forward as the chronically unemployed lose their purchasing power when entitlement cuts kick in.
Irrational Market Action
The only argument for stock prices to be within a stones throw of all time highs on the major indices and making new highs in some sectors, is the ridiculous assertion that "the trend is your friend". Certainly one can make the case that in recent weeks we have moved higher but it's hard to make a case for this move being a trend.
From a longer term vantage point the S&P 500 remains a little below its 2000 highs. Twelve years and we have gone nowhere - that's not a trend. Even looking at the market action since the recession it is hard to suggest that we are trending. What we have done since the recession is trade up and then down and then up and back down again each time failing at the high end of a rather obvious trading range.
The irrational aspect of market action is that we are at the high end of the range and close to all time highs while facing major headwinds. However, what makes it even more incredulous is the fact that we are in all probability going over the fiscal cliff and into a recession after the first of the year. Additionally, we have taken every stimulus action we can think of to no avail. We can no longer feel comfort in the fact that the Fed has our back. By their own admission they are out of bullets. Bernanke concludes his Jackson Hole speech with the following remark:
"Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in the labor market conditions in a context of price stability." Bernanke speech at Jackson Hole, August 31, 2012.
Now if there are those out there who see QE3 in a different light than Bernanke does or sees the "fiscal cliff" in a different light than the CBO does then so be it - embrace the irrational logic that "the trend is your friend" and "Ben's got your back". No doubt Ben does have your back but he has been severely crippled and for the moment at least the market - trend if you want - is moving higher.
Just know that the market's behavior is currently acting irrationally. As Bill Gross stated recently, the "cult of equity" is dead. What he means by that is not that stocks will not in the future be viable investments but that the reliance on a steady appreciation in stock prices is for the moment at least, a thing of the past.
If you choose to cling to the long term investment philosophy in today's economic environment then so be it. Just think about what you mean when you say you are a long term investor. A quick look at a stock chart - the S&P for instance - and you will see that a buy and hold strategy hasn't been very profitable over the last 12 years. If you don't think 12 years is a long time then at least recognize that we have been in a rather broad trading range for 12 years and our economic headwinds don't bode well for breaking out to the upside and putting in a major leg up at the present time.
An investment with a risk/reward of less than 1:2 is just not an investment worth making. If we remain in this broad trading range with the lower end of the S&P around 900 and the upper end 1500 then the upside at the present is about another 100 dollars and the downside is 500 dollars. That is a risk/reward of 5:1 - not a good play.
Just keep in mind that there are alternatives and you don't have to be invested in stocks or bonds and you don't have to play the short side of the market. Consider that cash is an investment asset despite the fact that almost everyone will tell you it's not.
Cash moves inversely and in direct proportion to the asset you would acquire with that cash. If you forego a stock purchase and that stock drops by 50% you made 50% on your cash relative to that stock. In other words you still have your cash and you can now by twice as many shares.
Play it as you see it and good luck. Keynes is right when he said "The market can stay irrational longer than you can stay solvent." This is also a truth - the market will eventually get it right and the underlying fundamentals will be reflected in stock prices.