What Bothers Me About the U.S. Stock Market

There’s too much optimism compared to actual data and recent trends, at least so far as I can see.  Here are some examples.

The Financial Times has, behind a firewall, an article out today showing evidence of falling demand for petrochemicals in China that, the writer says, raises the question of whether China’s industrial slowdown is accelerating downward faster than expected.  Then the article twice goes on to proffer market participants’ expectation that this is just a brief pause in growth; the pause that refreshes.

Both du Pont and Texas Instruments pre-announced weak earnings for the current quarter this week, but each stressed they are optimistic for a quick turnaround, citing low customer inventories.  (But will inventories appear “too low” if new orders surprise to the downside?)

The Reuters/U-Michigan survey of consumer confidence reported a nice jump in future expectations but practically no change in current conditions.  Many Fed manufacturing surveys have shown this as well lately.

The Bloomberg Consumer Comfort survey (formerly run by ABC and before that by ABC-WaPo) has shown worse estimates of personal economic circumstance for a longer period (3 months) than even in 2008-9.  Gallup’s discretionary spending data is similar if one adjusts for price changes, and Gallup has shown for well over the past three years a strong continuous majority of respondents reporting the economy worsening.

Meanwhile, many observers report that corporate profit margins are at or near modern records, and different measures of Tobin’s q or its variants (replacement costs for corporate assets), or a somewhat similar measure that John Hussman reported on recently, suggest as well that the general stock market is substantially overvalued.  

Meanwhile, it is impossible to discern whether Europe is first going to flirt with price deflation before all the money-printing that I expect leads to the usual result of price inflation following monetary inflation.  But with imported oil into Europe, the U.S., and Asia remaining above $100/barrel, an ongoing tax on industry and spending is continuing that in the past has correlated with recession- and the longer and higher the oil price has stayed, the deeper/longer the recession.

Back in the U.S., two measures of earnings momentum are ominous.  In the earnings season just passed, it was reported that there was a higher ratio of Q4 earnings downgrades to upgrades by reporting companies than since 1998.  People may remember that the real economy actually peaked in the 1997-8 period known as the Asian contagion, ending with Russia going into hyperinflation and the collapse of LTCM.  It was in part the system’s (read, the Fed’s) money-printing response to the LTCM mess that helped set off the amazing surge in stocks for the next 1-2 years, all of which was soon given back (and then some).  Then, this past week saw a report that channels the 2001 recession:

Companies cutting forecasts outpace those raising estimates by the greatest ratio in 10 years, and some sectors, such as materials, have seen a dramatic fall in expectations for the soon-to-be ended fourth quarter, according to Thomson Reuters data.

It is a stark reminder that even as U.S. economic data has improved in recent weeks, the euro zone debt crisis and concerns about slowing growth in China still cast a long shadow.

Estimates for fourth-quarter S&P earnings growth have tumbled over the past two months as global macroeconomic headwinds prompted analysts to slash forecasts.

The S&P is now seen posting earnings growth of 10 percent in the fourth quarter, down from a forecast for 15 percent growth on October 3…

So when I read this, I see optimism:  growth, problems elsewhere in the world but not the U.S.  

To me, the simpler approach to take is that corporate earnings are being richly valued relative to the actual value of corporate assets, including net cash, and that these earnings are further being richly valued based on peak profit margins.  Meanwhile, the populace keeps reporting, for the first time since records are available, that the cyclical rebound in industrial and other production has not been associated with any improvement at all in their financial situation- actually, they report a steady worsening.  Said worsening is of course because wages and jobs have stagnated while living costs have risen, while the average value of household assets (financial and real property) have at best stagnated.

Furthermore, and unlike the period in the post-1932 era well past the end of WW II, stocks are not inherently viewed the way they used to be, which is inherently risky assets that, after all, require a leap of faith to own.  Unlike lending to a corporation or municipality, which are contracts with indentures, the purchase of a common stock is a pure investment without even an implied promise from the company that it will seek to maximize the value of outsider shareholders’ shares; and most large companies today have minimal levels of insider ownership and minimal to no insider buying other than to exercise and promptly sell in-the-money stock options.

There’s no way to know, but I think it’s reasonable to look at the way Big Finance was acted with Other People’s Money and shy away from any belief that it’s different this time.  For the last 111 years, the linked chart suggests that stocks will at some point fall below fair value.  If so, a large drop in stock prices could soon follow the rapid deceleration in earnings growth especially should actual declines in profits be projected.

Thus it just may be that a general market complacency could be replaced sooner rather than later by something more like what most of the country already believes, which is that the Great Recession only ended in the securities markets but not in the real world.  If it is occurring or occurs soon, a clear new cyclical downturn in the U.S. could therefore end up having a disproportionately greater effect on stock prices than on the real economy.

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7 comments to What Bothers Me About the U.S. Stock Market

  • dd

    Doc, i think we fundamentally agree on the core of what is going on with the economy, and what is wrong with it. but it is what it is, as they say, and this is what we have to deal with; so that said, i massively disagree. i am not a bull on the market, but to say it is materially overvalued seems like a stretch.

    1) the direction of the economy is often disconnected with the valuation or direction of the stock market. whatever ISM or PPI or inventory number was just printed is old news, and the inevitable rearview adjustment to those numbers is even older news.

    2) other than the Fed liquidity similarites, i do not think 1998 is at all a good comparison — we’ve had loose money all along since 1998 anyway.

    in 1998, with the ten year Treasury at roughly 5%, the s&p closed at roughly 1230, with LTM earnings of $45, so 27x earnings. inverse that and you get an “earnings yield” of 3.7% … so the yeild was inside the ten year.

    in 2011, the s&p is at roughly the same level as 1998 and its earnings have doubled. the current “earnings yield” is roughly 7.5%, which is 550 basis point wider than the ten year.

    it’s not at all a comparable situation from an asset class valuation standpoint.

    3) this is most important: we don’t talk individual stocks here but boy, i can point to numerous individual stocks, many of them mega-cap, household names paying dividends in excess of the ten year yield, many of which are buying back shares in excess of what shares they give away … companies that generate prodigious operating cash flows well in excess of their capital expenditure needs (as opposed the U.S. Treasury which spends 10% more than it brings in), have fortress balance sheets (many with large net cash positions), and many are selling at 8-12x earings.

    all the tomfoolery with options and bad behavior and bad capital allocation aside, stocks are still not materially over or undervalued in this context. there are, and there always will be, stocks that are overvalued within any market. for instance, i wouldn’t buy a bank, any bank, with YOUR money. but in about 1 minute i could add up 1 trillion dollars worth of market cap companies, ones that everyone has heard of and uses their products daily, that is not largely overvalued based on current business fundamentals.

    i say this with some trepidation and in deference to your spot-on Treasury calls, but isn’t the U.S. Treasury alot worse in all of the above facets?

  • dd

    i forgot to mention that, as much as i agree that the financial news community is clearly bullish recently, they usually are — i’m a big believer in the old sayings, “talk is cheap,” and, “money talks and BS walks.”

    on that front, i’d note two things:

    1) i’m not a big believer in money managers who seek press or publicity. long-only, asset gathering outfits form the vast majority of the market, and they are almost always bullish as this stance suits their mandate and incentive structure. as for journalists, they should stick to reporting.

    2) equity fund flows have been negative for a long time, since early summer as i recall. investors are voting with their feet, they are bearish on stocks, and so what a reporter or laggard money manager says really is inconsequential. stock prices do not represent all that much optimism, in my opinion.

  • This is what makes markets- different ways of looking at the same thing!

  • Mike

    Given that the London metal’s exchange(LME) warehouses are overflowing with base metals, this is a firm indicator that things are getting worse. The only hope is that such is glut is being intentionally caused by Goldman Sachs to drive up prices.

    For those of you who are unaware Goldman Sachs owns many of the LME warehouses.

    http://www.reuters.com/article/2011/07/29/us-lme-warehousing-idUSTRE76R3YZ20110729

    http://globaleconomicanalysis.blogspot.com/2011/11/lme-wharehouses-in-us-overloaded-with.html

  • these day due to the fight in European countries the market goes down…
    a big crisis in the market today still the Indian market gets down and dollars prices hikes … for MCX Commodities as well as NCDEX Commodities….