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Christopher Mahoney
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I spent eight years at Bank of America in New York (1978-86) covering Wall Street, then moved to Moody's Investors Service where I worked for 22 years, covering banks, sovereigns and corporates. I chaired the Credit Policy Committee for four years. I retired in 2007 as vice chairman. PLEASE... More
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Capitalism and Freeedom
  • Why Stocks Keep Shrugging Off Bad News 0 comments
    Aug 4, 2012 3:27 PM

    An observer of the U.S. equity market would have to conclude that it has a strong bullish bias. Despite the weak economy, a clouded earnings outlook, persistently high unemployment and the European Sword of Damocles, the market shrugs off bad news and spikes on anything that can be construed as good news, no matter how tenuous.

    The Fed fumbles the ball, the Bundesbank shows Draghi who's boss, Southern Europe teeters on the brink of something awful--no problem! All news is good news. Girls just want to have fun and the market just wants to go up.

    Why is this? Is the stock market irrational? Perhaps, but it is being paid to be irrational.

    What is happening can be summarized in one well-worn sentence: Don't fight the Fed. Since 2007, the Fed has: cut the overnight rate from 5.5% to near zero; grown its balance sheet from $800B to $2.7T; grown M2 from $7.2T to $10.0T ; and driven down 10-year Treasury yields from 4.6% to 1.6%. (For comparison, the Fed has bid up the PE ratio for Treasuries from 22 to 63, not exactly "value" territory.)

    The Fed has systematically banged fixed income yields down to levels not seen in 50 years. The Fed is charging you for holding bonds and paying you to hold stocks.

    At present, the forward PE on the S&P 500 is 13.3, the earnings yield is 7.5%, and the Equity Risk Premium (earnings yield minus bond yield) is 6%, which is very high. If you were a fiduciary (such as a pension manager), you would be hard-pressed to defend an overweight on fixed income when it yields nothing, versus equities that offer an attractive 7.5%.

    The case for equities is compelling, and the relative "economic return" almost requires you to sell bonds and buy stocks. When stocks get this cheap, and bonds get this expensive, bad news has been fully discounted. Future news will have to be really really bad to hurt stock prices.

    To be bearish (like me), one has to expect catastrophe with a pretty high probability. A catastrophe that is bad enough to drive investors out of all risk assets and into Treasuries, and to keep them there by hitting the earnings outlook or cratering the financial system.

    We went through that exact scenario in the six months from September 2008 until March 2009, when the Dow declined by around 40%. That was because of a panicked flight to safety; it had nothing to do with relative yield. No equity market, no matter how priced, can withstand the risk of imminent financial collapse.

    If an investor believes that Europe will figure out a way to save the eurozone, he should be in equities, because they are already priced for very bad news. If you believe, like me, that things will get much worse before they get better, then you should be underweight risk assets. But you will be taking a big risk that the world will not end this year.

    The Dow has doubled since the crisis, and there has been an overhang of really bad things all along; the market has climbed a wall of worry. You therefore have to be both very cynical and very certain to believe that Europe will really blow up. But that is where my bets are.

    Disclosure: I am long TLT, GLD.

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