Why the Market Is Not a Forward Looking Indicator

Includes: QQQ, XLP, XLY
by: Logan Smyth

I’m sure there are plenty of investors who will scoff at the thesis of this article after reading the title. After all, in a free market economy the equity markets are supposed to reflect investors’ perception of future earnings. However, looking back over the past decade or so, it seems as if this has rarely been the case. Rather, equity markets are mean-reverting mechanisms that react to investors’ irrational levels of optimism or pessimism. Were markets correctly pricing future earnings in March 2000 or October 2007? What about in March of 2009? What about now?

Over the last two months, the markets have staged a massive rally in anticipation of another round of quantitative easing. It seems as if most analysts, investors, and pundits have been praising QE2 as the solution to all of our problems. Even worse, they are pretending as if there are no possible negative repercussions or end to the rally in sight. Personally, my favorite take on QE2 was Jim Cramer’s reckless analysis on Thursday. My two favorite comments were “We're investing to make money, not make predictions about the economy.” and “If you can buy stocks that rally like they did today, because of this Bernanke plan, you can also sell those stocks after they've rallied.” Both of these comments are completely absurd. His audience is mostly amateur investors and frankly this is horrible advice.

Despite what I consider to be the absurdity of Cramer’s comments, they actually echo much of investor sentiment right now. It is that sentiment that I plan to refute in this article. The basis of my argument centers on the Fed’s decision to announce further quantitative easing and what I believe that means for the markets. Let me begin, though, by saying that quantitative easing is complicated and has effects that will be felt around the globe. As such, it is unreasonable to expect I could succinctly cover the topic in its entirety in one article. Instead, I would like to call attention to a couple things I find particularly troubling in the hopes of fostering an intelligent discussion.

By now, most investors should be well aware of the Fed’s intentions with quantitative easing. Essentially, the Fed is expanding its balance sheet to purchase treasuries in order to force interest rates even lower, prompting greater investment in a variety of asset classes. This effect is achieved because the Fed is printing money and driving the value of the dollar lower. A weaker dollar means dollar-denominated asset prices will increase on a relative basis. Further, a weak dollar means American made goods are cheaper overseas and should help increase exports. The hope is that inflated asset prices will give investors a “wealth effect”, leading to increased spending and job creation. It is my understanding that this is quantitative easing in a nutshell.

My first concern is with the term “wealth effect”. It is not wealth creation. Rather, the prices of the assets you own increase because they are worth less in dollar terms. The hope that this will fool investors or businesses discredits their intelligence. Certainly major corporations are not this stupid. Most of them operate in many countries and are well aware of currency effects. Even individual investors should be somewhat aware of the inverse relationship between equities and the dollar, they have mentioned it on CNBC everyday for the last five months. If anything, the Fed may be able to fool amateur investors who take a more passive approach. However, this seems counterproductive to the necessary deleveraging most Americans are still going through.

After watching the markets hit two-year highs Friday, I decided to look a little deeper into the inverse relationship between equities and the dollar. What I found was fairly surprising. On June 9th, 2010, the Dollar Index futures hit a high of $88.91. They closed Friday at a low of $76.76. In the past five months, the price has dropped 13.7%. Over that same time period, the S&P 500 has moved from a close of $1055.69 on June 9th to a high of $1225.85. The rise in the S&P 500 over the same time period was 16.1%, pretty close to the decrease in the dollar. I decided to calculate what the S&P 500 would be worth today, based on the June 9th valuation of the dollar. The answer? $1057.91, only 0.002% higher than 5 months ago when the recent rally began. This helps to emphasize my point that the “wealth effect” is merely an illusion and a lousy one at that. (I should note this is rough math. I arrived at my valuation by taking the product of the fractional dollar value and the closing price of the S&P 500 at the end of the time period.)

My second concern with further quantitative easing actually pertains to its effect on the Americans who likely have no understanding of what the Fed is doing – low-income, underemployed, and unemployed Americans. This group of Americans is most accurately represented by the real unemployment rate, which most experts peg between 15% and 20%. For these individuals, the “wealth effect” is irrelevant. The majority are either dependent on unemployment benefits or living paycheck-to-paycheck.

Times are especially tough for this segment of the American population and those problems are about to be exacerbated by the rapid devaluation of the dollar. As I said earlier, a weaker dollar means dollar-denominated asset prices will increase on a relative basis. This increase includes the price of commodities like gas, food, clothing, etc. In the same time period referenced above, heating oil futures have increased 19.5%, wheat futures have increased 70.1%, cotton futures have increased 74.7%, and corn futures have increased 73.4%. I have placed the chart for cotton futures below to illustrate this point.

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This increase in commodity prices is being driven, in large part, because of the Feds systematic weakening of the dollar. In the short-term, the spike in commodity prices will be offset by hedges retailers and manufacturers likely have in place. However, in the long-term these price increases will eventually be passed on to the consumer as hedges expire. This, I believe, will be a pivotal point in the story of our economic recovery.

When these skyrocketing commodity prices get passed on to the 15-20% of Americans that are really struggling to get by, they will have a HUGE impact on their budgets and their quality of life. If wages are not able to keep pace with rising costs, consumers will really be in a difficult position. Simple economics will tell you if price increases outpace income growth, demand will decrease. Argued another way, companies could absorb rising costs to maintain demand, but the result would be shrinking profit margins. Either way, I am of the belief that consumer staples and consumer discretionary stocks in particular have a rough road ahead of them. The effect of rising prices is not reflected in stock prices now, but it is my belief that this realization will begin to sink in with analysts very soon. In fact, the Wall St. Journal actually ran an article on Friday discussing this very problem. If you’re interested you can read it here.

Here is my understanding of the situation and why I think the Fed is playing a very dangerous game. The Fed is printing money to increase asset prices in the hope that people spend money they don’t really have to create jobs. While these jobs would be based on artificial demand, the hope is that lighting a spark would get the economy moving in the right direction and the demand will eventually fill in as people with new jobs begin to spend again. In the meantime, the Fed is racing rapidly increasing commodity prices that will eventually be passed on to the consumer. In the end, it all comes down to timing. In my opinion, the Fed is taking a very sizable risk in the hopes it can time this spark correctly. If it fails, as a nation we will have borrowed another $600 billion and will have little to show for it.

After watching the events of this past week unfold, I have turned decidedly bearish on the markets. In the past few days I have heard far too many comparisons to the 2000 tech bubble. Investors’ attitude seems to be if it keeps going up, why not buy it and sell at the top to make a quick buck? People are choosing to ignore the stagnant unemployment rate, the uptick in unemployment claims, inflation that is trailing Fed targets, weak GDP growth, and a host of other mediocre economic data. There are plenty of cliché sayings that seem appropriate right now, but my favorite is Warren Buffett’s classic idiom “be greedy when others are fearful and fearful when others are greedy”.

At the end of last week I positioned myself quite short. The Nasdaq 100 ETF (QQQQ) is within 2.5% of its 2007 high, despite a starkly different economic picture than three years ago. The ETFs that track consumer discretionary (NYSEARCA:XLY) and consumer staples (NYSEARCA:XLP) are both trading right at their May 2009 highs and are not far off their 2007 highs. I’m positioning myself with puts on the QQQQ and a short position in the XLY. I wanted to short the XLP as well but was unable to borrow the shares, so I increased the size of my short position in the XLY. I also went short Netflix (NASDAQ:NFLX) after their 11% pop on earnings. The company is currently trading at 65x earnings (TTM) and if I am correct in my assumptions, Netflix will be subject to a harsher selloff relative to the broader markets.

As an interesting closing thought, when looking at the Nasdaq 100, I thought the recent weakness of the dollar might have had some effect in its recent climb to 2007 highs. Quite the contrary, Dollar Index futures are actually trading within 1% of their November 2007 price. The historical chart below shows that the Dollar Index is essentially trading at the exact same level it was right before the 2007 collapse of the equity markets. Essentially, the market feels the Nasdaq 100 should only be trading at a discount of 2.5% to its 2007 highs. I find that very disturbing given the many economic uncertainties we have yet to resolve, let alone the fact we only reached 2007 highs because consumers were bingeing on cheap credit…just food for thought.

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Disclosure: QQQQ Puts, Short XLY, Short NFLX