Thomas Ryan's  Instablog

Markets are pricing in a dramatic improvement in fundamentals which often happens after steep recessions. If one believes that demand will return to where it was earlier in the decade, we would see a sustained period of dramatic growth justifying the fastest surge in stock prices since the 1930’s. A growing middle class in China, India, South East Asia and South America is going to lead to increasing domestic consumption in these countries for decades to come. Most importantly, the massive government stimulus packages in the United States, Japan, China and Europe have begun to work as intended. This is causing factories that produce machinery, steel, aluminum, household appliances, furniture and cars which were idled for much of the first half of this year to restart in the second half leading to a massive surge in GDP growth worldwide. This surge will create a virtuous cycle that will cause consumer spending and corporate profits to increase and unemployment to decline. This is the bull case for stocks.

Anyone who has sat on the sidelines since my last letter has lost opportunity, and the market may indeed go higher in the near future. Like all good stories there are a number of truths to the above scenario where one can make a case that the things are getting better. The future certainly looks more promising for emerging markets than it has in the past. The massive increase in bank lending in the first half of the year in China has increased consumption. Some factories will indeed need to be restarted, for a short time at least, after being idled. We believe there is a growing disconnect between the rational expectations for the future and current market prices. This disconnect is due to the massive amount of liquidity pumped into the financial system which is flowing into the financial markets. It has become increasingly clear to us that the underlying fundamentals of both the US and world economy do not justify the price increases that in equities. Money is flowing directly from the world’s biggest banks into the stock market and commodity markets. Similar to when the internet bubble was inflating, prices on many stocks have lost all connection to the underlying earnings power of the business. People will come up with good stories to justify the price increases as long as stock prices keep rising, and mutual fund managers will talk of V shaped recoveries.  Just like when internet stocks lost touch with realty in 1999, it did not mean that prices would immediately drop. We would like to urge a word of caution however, and advise those who have profits to take them now. If you did not sell before the 2008 crash, now is the time to sell.  This rally is going to end in tears for those who hold on for too long. At some point reality will take hold, and there will be almost no place to hide.

We looked at the universe of companies traded on the US exchanges that have volume of at least 100,000 shares a day, market cap of 25 million dollars and revenues of 25 million a year. Only 84 of the 2408 stocks that meet these criteria have declined for the period from March 6^th through November 10^th. Many stocks were trading as if they were going into bankruptcy at this point, particularly in the consumer discretionary and retail space. The opportunities that existed at this time have disappeared with the rally. 953 of these stocks we screened have advanced more than 100% since the March low. Out of these stocks only 399 have positive net income, the rest lose money. 101 stocks have advanced more than 500% since this time. The biggest winners are Dollar Thrifty, Avis Budget Group, Smurfit- Stone and Dana Holdings up 2980%, 2960%, 2350%, 2230% respectively. The net incomes of these companies for the previous twelve months respectively were -49 million, -1.18 billion, -2.82 billion, and -684 million. ArvinMeritor and Tenneco made the top 10 list with gains of 1790% and 1770% respectively, while losing a combined 1.87 billion. Smurfit Stone is currently bankrupt, and there is still a significant chance that some or all of the other companies will declare bankruptcy as well during the next year.

The trade deficit increased at the fastest pace in a decade in July, and oil prices have increased on average over $10 from the second quarter in August and the first half of September. We could see a large increase in the trade deficit, which would be a negative headwind for GDP. Inventories are still contracting, falling 1.4% in July from the previous month. There are no signs of the expected inventory build that is being thrown around on CNBC as a veritable certainty this quarter. Nor should we expect to see one. Sales were down 19.8% from a year ago according to the September 11^th commerce department report, but inventories have only dropped 12.8%. The sales to inventory ratio is still well above pre-recession levels. Unless we see a large inventory build in August and September this will be a negative headwind as well.

This leaves only government to boost GDP in the 3^rd quarter. Does anyone really want to buy a market where the Russell 2000 has surged over 80%, based exclusively on government stimulus. The GDP number coming in weaker than expected is not necessarily the catalyst that will make this rally end, but it is certainly a risk. Much like when the “America’s Oil Crisis” CNBC special came within a few weeks of the market top in oil, one has to believe the “ Banking on Geithner” special is a sign this rally is just about over. Geithner has done nothing to fix the banks. He has not addressed any of the issues in a meaningful way. Lending is plummeting at the fastest pace on record specifically because the issues with the bank’s balance sheets have not been addressed. Those of you who don’t have to invest should probably be on the sidelines at this point. If you are worried about missing some upside, use a trailing stop on your positions. There are massive risks right now that people are blissfully ignoring in the financial media. This rally is going to end very badly for those who are late to the party.