Despite the constant noise of the mainstream script, the tug-of-war between central bank reflation and the deflationary effect of extreme global indebtedness is the real story. We don’t feel compelled to choose sides because our approach to valuations suggests we should be happily agnostic in the inflation/deflation debate. As is always the case, we are positioned based on bottom-up analysis, but pay significant heed to the big picture.
The market’s primary narrative remains that the Fed can taper QE because growth is so strong due to its own efforts. In other words, they’re patting themselves on the back for something they really haven’t done. Also, according to the doctrine of the script, emerging markets like Turkey may look a bit troublesome, Argentina and Brazil may be imploding, and China may finally be facing the downside of a credit bubble, but those issues are contained. Plus, the weather in the U.S. is completely responsible for any bad news here. This logic makes us shiver. An end to the script would be as welcome as an end to winter weather.
We understand their motives, but remain outside the cult. We wonder what’s in the Kool-Aid most are drinking that twists reality into the pre-approved storyline that supplants the truth and alters perception so completely. Along those lines, market optimism as expressed by extreme levels of margin debt causes us to wonder if maybe marijuana use was legalized and encouraged on most trading floors last year. No wonder cannabis-related equities have been hot items driven, we thought, by state-level legislative changes, but maybe other factors are at work as well.
Bad news remains ignored or spun. More than anything, the 24/7 linkage between the dollar/yen and S&P500 futures reminds us that a massive crowd is on board the market cruise ship with rough seas ahead. When the computers decide that it’s time to head to port instead of bidding stocks every quarter-hour of the trading day the passengers will stage a mutiny.
Evidence of deflation and weak growth, often hidden so well under the veil of the script, made itself known recently. Besides two bad employment report so far in 2014, Amazon’s disappointing revenues (same as most other retailers) seem to make clear that Holiday sales were not commensurate with the S&P500 at 1,850. Weather is not the only factor when the biggest internet retailer posts disappointing numbers. Considering it was just reported that real disposable income in the U.S. rose only 0.7% in 2013 (weakest since 2009) and unit labor costs were down 1.3% in the fourth quarter, such retail weakness only makes sense. Especially when inflation in the stuff most people need to survive is much higher than the government tells us. Elsewhere, real base wages in Japan hit a sixteen-year low in 2013 in spite of QE efforts there that make our Fed seem lazy.
Apparently, according to our most telling anecdote of economic troubles, even liquor is not selling well in emerging markets as Diageo management informed us. That helps explain the much discussed tremors in those regions. Pockets of relative strength remain domestic industrial and commercial real estate markets, but we wonder how long that can continue with final demand for goods so shaky. For instance, real estate developers are responding to false signals emanating from public equity markets. Someone might want to tell them that the data of each passing month suggests that the U.S. is over supplied with malls and shopping center square footage. We recently read that trips to the store are down massively in the last few years, but fearless developers need nothing more than to see rising stock prices to make them want nothing other than to erect a new strip shopping center closer to some yet undiscovered slice of retail spending power. Clearly they ignore our letters and maybe they know something we don’t, but we think that after twenty years of this gig, we might recognize this sort of massive capital misallocation inspired by the Fed’s easy money. We suspect that the order book at Boeing is replete with more than a few jet requests predicated on the belief that things just must be really great because CNBC tells all who will listen that internet stocks are surging.
We think it is really quite simple. Because QE has not helped the real economy in the form of income growth and remains just a “magic trick” favored by hucksters who just don’t know what else to do or talk about, record equity valuations should continue to become suspect on a name by name basis when more companies disappoint in coming quarters as their earnings are reported. The system remains tenuously stable as government transfer payments are used to placate the masses who are encouraged to further indenture themselves to personal debts which become impossible to service, yet help maintain spending habits. The Catch 22 is that if money velocity rises and wages begin to reflate, then corporate earnings, profit margins and stocks will come under pressure.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.