As the DJIA prints new highs, we see more and more investors, novices and veterans alike, swimming further and further from the shore. They are placing their trust in lifeguards (central bankers) who have no more experience than tossing a few life preservers into the water while keeping their own feet in the dry sand. In our view, this is a risky proposition. Do they even know how to swim?
Let’s dive a little deeper…
The $85 Billion Austerity Sham – Last month’s histrionics over $85 billion less growth in government spending over the next year would have been comical if they were in a book of fiction or a movie. Instead, the tragic reality is that those with a vested interest in perpetuating the fantasy that is known as our “something for nothing economy” fear that our now grotesque federal spending machine may be slowed down just a little, exposing the obvious futility of having already wasted hard-earned money and handing a still growing $6-trillion tab from the last few years to our kids. Despite these horrific sums, growth is not self-sustaining after four years of this program and the powers-that-be do not want us to know it.
Just look at how recent growth in debt compares to the entire history of our nation. It is baffling that so many professional investors seem to believe that the government can take huge sums from the real economy forever without some nasty repercussions. The unsustainability of this fiscal madness should shrink multiples, not expand them in our view because over the long-term this debt burden will slow growth.
The Gamers are Allowed to Play by their Own Rules – Equity players, aided and abetted by the media and talking heads, were able to game their way through another month because all the financial media will talk about is central bank activities in spite of earnings reports that raised more doubt than confidence. One of the elements of the markets that trouble us the most is the prevalence of apparent gaming that goes on. We talked before about the fact that about 70% of trading volume is done by high frequency traders who simply move positions among each others’ computers in rapid-fire fashion. Overall volumes remain very light, so gaming is easier.
We have been around the block a few times and are reasonably familiar with tactics used in multiple markets to create a desired picture, but we are astonished by how often during a day it seems that the only desire by traders is to create a perception and to rescue a falling market. More than anything, the only desire appears to be to raise the price of an index or stock by buying with no intent to accumulate positions at lower prices. We are not naïve. We well know this has gone on since the dawn of creation, but we can’t recall a time when it was the only game in town. It is not just month-end performance gaming or option expiration day activity. It is daily and by the minute! We do not take these shenanigans as a sign that markets are dominated by investors with long-term strategies in mind and we think this is a crucial distinguishing element that goes unnoticed by many observers who just look at closing index levels. We ask where stock prices go when the gamers stop gaming.
Real People and the Real Economy – Last month we mentioned the negative GDP print for the fourth quarter of 2012 (since revised to positive 0.1% from negative 0.1%) and based on what we are hearing from real people dealing with the real economy, things are not going swimmingly so far in 2013. The managements of retail and restaurant chains (like that of WalMart, Target, Red Lobster, and Olive Garden) sound depressed because patrons are not showing up in a manner befitting the ebullient stock market. Auto sales in the U.S. look like a rare bright spot for now because dealer incentives are high, but we wonder how long that can continue with gas prices hitting record levels for February. European auto sales are a disaster and VW does not sound too excited about the rest of this year.
Producers of commodities like BHP Billiton are cutting production because the China engine is slowing. BHP’s CEO recently said that “over the next five years, we are going to go from a growth rate in minerals demand of 15 percent to 20 percent a year to 2 percent to 4 percent a year,” according to Bloomberg. We contrast these anecdotal reports with Wall Street expectations of better growth and much better earnings as the year progresses. Oddly, we do not recall a real bull market continuing when Goldman Sachs and JP Morgan were announcing layoffs as they did last week. Caterpillar just released dismal monthly sales results, calling into question optimism over global infrastructure and construction spending. Let’s just say that we remain skeptical.
Hedgers have Stopped Hedging – Speaking of skepticism or lack thereof, the latest short interest figures are simply astounding because they express the high degree of confidence market participants have towards equities. According to Bloomberg “investors reduced bearish stock bets to the lowest level since at least 2007. Short sales in the Standard & Poor’s Composite 1,500 Index fell to 5.6 percent of shares available for trading in February, down from a record 12 percent during the credit crisis and the lowest ever in data compiled by Bespoke Investment Group and Bloomberg starting six years ago.” We just say “wow!”
Such a low level of market hedging runs counter to the limited growth prospects we see and we are not totally alone. We think Barron’s recently might have had it about right: “GDP could shrink in the first and second quarters — two consecutive declines is the popular definition of a recession — and stretch into the third quarter, according to Charles Dumas of Lombard Street Research in London — a prospect he says Wall Street is ‘blithely ignoring.’ Federal spending could be reduced by 0.5% under sequestration, which would come atop the 1% fiscal tightening under the 2011 debt-ceiling agreement and 0.8% impact of the end of the payroll-tax cut on Jan. 1, he points out.”
That looks quite troublesome to us, but the talking heads seem reluctant to discuss what effect this might have on earnings over time.
With these thoughts in mind, we see no reason to swim further from shore as bad weather hits just because the lifeguard has a good recent record for rescuing drowning swimmers. The current investment climate remains treacherous and faith in the Fed (the lifeguard) is extreme. Essentially what the Fed is officially saying is that it needs to continue QE because the cycle remains weak. Why should one pay high multiples for earnings given this admission? We also wonder if those with faith in the Fed will keep that faith if profit margins contract by one-third to a more typical level, which seems likely if fiscal policy slows as expected. We fear what happens when markets lose faith in the Fed to any degree because we simply cannot fathom that trust could go any higher.
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.