You’re a brave man. Go and break through the lines. And remember, while you’re out there risking your life and limb through shot and shell, we’ll be in here thinking what a sucker you are.
– Groucho Marx in Duck Soup
The US S&P 500 Index shot to over 1,000 on Monday during the day while other indicators of risk all shrunk. Deconstructing the arguments, one notices a range of self-contradicting answers that are at the heart of the current phase, even as everyone blithely ignores the only real answer to the question.
The following is a summary of observations gleaned from the financial media over the past two weeks. As world asset markets entered a new phase of expansion, I would suggest readers pour through the multiple answers that can be found in every major financial media outlet in dealing with the four questions asked below. The choices are ranked as per their frequency of occurrence based on my own unscientific survey of media outlets over the two weeks.
Question one: Why are US stock prices rising?
1. Earnings are better than expected.
2. Inflation is low and other macro-economic data are also better than expected.
3. Investors need to add to their stock positions or risk missing the rally.
4. Low interest rates make dividend income more attractive, and stocks more valuable.
Question two: Why are commodity prices rising?
1. Economic growth is better than expected everywhere.
2. Money is being diverted to real assets because people have lost faith in the US dollar and the euro.
3. Interest rates are low, allowing speculators to buy more.
4. Speculation will be reduced, so everyone is increasing their positions now.
Question three: Why are emerging market (EM) credit spreads improving (tighter)?
1. Commodity prices have risen and will further rise.
2. The International Monetary Fund is making money available.
3. China will do bilateral deals for commodities denominated in yuan to avoid as much as possible using the US dollar.
4. Market-priced refinancing is now available.
Question four: Why are interest rates expected to remain low?
1. Central banks remain worried about the fragile position of commercial banks.
2. Inflation remains low as rising commodity prices are offset by lower consumer spending on other items; that is, economic growth is not rebounding quickly enough.
3. Emerging market countries will continue to buy the debt issued by Western countries only if low interest rates can “guarantee” them no alternatives.
4. It’s the only way for current heads of the world’s major central banks to keep their jobs.
I would suggest a quick repeat reading of the answers before proceeding to the next section.
Looking through the maze
In this section, let us examine the various alternatives that suggest significant logical inconsistencies, factual errors or plain bad math. Readers will have noticed most of it, but here are a few ideas anyway.
First fiction: Earnings are better than expected. By far the biggest propellant of equity valuations is the notion that share prices deserve to go up because companies’ earnings “beat” analyst expectations. This raises a serious intellectual question of why any investor would even bother thinking about the equity analysts who failed to say anything useful about the stock markets from 2005 to 2007, and then consistently lagged the market through the course of 2008.
That aside, readers should probably appreciate some back-to-basics here: say that a company made $1 per share annualized in 2005 and traded at a multiple of 15x, that is at $15 per share. Then it lost money in its “investment” portfolio in 2007 and barely avoided bankruptcy in 2008. This company, whose shares now trade close to $10 after the rebound in the second quarter, was widely expected to make $0.40 per share in 2009, but now appears to be on track to make $0.50.
So now, what should be the correct price of the share: 15 times 0.5 gives $7.50, which is 25% off the current price of $10; but instead, the factoid that it did better than “analyst expectations” has sent the share price to $12. This level is 24 times earnings. Why is that sensible for any investor? So the answer to this paradigm is simply that current stock prices already discount the recovery of earnings up until 2020 in most cases, which leaves little or no room for error.
Second fiction: Index herding makes sense. One of the more frequent comments I have seen and heard over the past few months is that investors must buy stocks now because if they “miss” the index rally, there can be no jumping back on the bandwagon at a later date.
This is wrong in numerous ways, but the most obvious is that buying into individual stocks because they are “beating analyst expectations” as in the example above doesn’t mean that investors can be protected from future disappointments. The idea of using exchange-traded funds (ETFs) to reduce idiosyncratic risk and increase systemic risk is also a poor one because the survivorship bias of American indices is rarely captured by ETFs.
For example, a number of failing companies such as financial and automotive companies are replaced by those with higher stock prices. While this keeps index base prices constant, it actually costs investors substantially more by the losses on failing companies and the rally they miss on the new additions because they are added to indices later on.
Basic math failures: What is good news anyway? Last week, financial media reported that the contraction of the US economy by 1% was “good news” because economists surveyed had expected a worse figure of contraction, by 1.5%.
Use basic math and keep in mind the fact that previous figures were also corrected: if – as Bill King writes in the “King Report” – Q4 08 gross domestic product (GDP) was 100 units, and Q1 09 was reported at minus 5.5% and Q2 09 GDP was expected to be minus 1.5%, the expectation was for GDP of 100 units minus 5.5%, or 94.5 units, minus 1.5%, or 93.08 units. But, with the revision of Q1 09 GDP to minus 6.4%, the Q1 GDP units become 100 minus 6.4%, or 93.6 units. So Q2 is minus 1%, or 92.664 units. In other words, the figures were worse, not better, than expected. 
Yet, read all the financial media headlines from last week and I almost dare you to find someone who did the above calculation to arrive at what is effectively a fairly simple conclusion. Really.
Contradictions abound (1): Inflation and the path of interest rates. Stock markets are assuming that interest rates will remain low, but this contradicts the most obvious assumption on the other side, namely that economic growth will improve enough to warrant earnings growth.
Central banks assume that inflationary pressure will remain low and yet stock prices for commodity-based companies have recently reached all-time highs. Cyclical companies have seen stock prices rebound, and yet the most important argument for central banks to restrain interest rates is that consumption has not edged higher in either Europe or the United States. The rise in stock prices of emerging market stocks – the best performers over the past 100 days – also belies the notions held widely by the Group of Seven central banks; the same is true for credit spreads of EM countries.
Contradictions abound (2): The role of the US dollar. One of the key constants for markets these days is that falling values of the US dollar correlate to higher stock prices and vice versa, in what is effectively a Mundellian portfolio rebalancing (named after Robert Mundell, the Nobel laureate). This is also the reason that interest rates on US government debt haven’t skyrocketed on the back of the significant increase in spending being signaled.
The problem is that, alongside, we have seen the expanded use of bilateral currency agreements by the likes of China, Iran and Latin American countries, effectively bypassing the US dollar. Increased use of such facilities dent the longer-term prospects of the US dollar and make the argument of portfolio rebalancing suspect for stocks.
To paraphrase the great Sherlock Holmes, whatever remains after one has removed all other possibilities, however improbable it may seem, is the truth. In this situation, the option that hasn’t been explained away is the vast horde of money that has been given to banks and other financial institutions globally by central banks since the great loosening of credit began over the course of 2008.
In effect, the only answer for rising market values for risk assets is that there is money chasing these assets – be they apartments in Shanghai or equities in New York. If there is one thing everyone has learned since 2007, it is that the single-best path to economic ruin is to buy something because (and only because) it is being chased by fiat liquidity.
Health warning: As with all my articles on stock markets, this one too carries the standard health warning. The aforesaid should not be relied on as investment advice, readers must consult their financial advisors or use their common sense.
1. This paragraph has been corrected to identify Bill King’s “The King Report” as the source, inadvertently omitted from the original. Our apologies.