April 28, 2015

US stock market in contrast to Real economy

A sage observer once remarked, "Speculation is going on when someone else is making money, and you and I aren't." Speculation (prompted by Fed policy) has been ripe, as hot money has raised the price of financial assets even in the face of disappointing progress in the real economy.

The U.S. stock market has lived a charmed life since the Generational Bottom in March 2009. Corporate profits have risen, inflation has been quiescent and valuations (price-earnings ratios) have expanded as stocks have more than tripled, while rising geopolitical tension, sovereign debt issues and other macroeconomic concerns have been ignored and dismissed.

How forgiving has the market been? The steady rise in stock prices has occurred despite a 1% annual shortfall in the rate of global Real GDP growth in each of the past three years and with consensus forecasts for 2015 S&P 500 earnings dropping from over $135 per share to below $120 per share in the last nine months.

For months I have suggested that a combination of fundamental and technical factors are conspiring to lend credence to the view that a broad and consequential topping process is being put in for both the stock and bond markets.

Now, more than ever, I continue to believe this to be the case.

Zero, and even negative, interest rates tend to lengthen (and distort) acceptable investor time frames. The tsunami of global speculation has been engineered by the world's central bankers who have, in the simplest sense, bought time for self-sustaining growth to appear.

Central bankers have added $10 trillion of new credit over the past six years. Taking a longer perspective, the stock of globally traded financial assets has increased to nearly $200 trillion today from $7 trillion about 25 years ago.

But slowing economic growth, a flattening in the yield curve, an acceleration of U.S. dollar strength and weakening business fixed investment offer indications in the near term that investors are growing impatient and time frames are likely shortening. 

Speculative capital, abetted by central bankers' largesse, has overwhelmed everything in its path -- regardless of sluggish macroeconomic conditions -- as natural price discovery in the capital markets has been distorted by zero interest rates and through the massive liquidity provided by quantitative easing.

But that distortion might now be ending and time frames might be shortened as the above signposts intensify. Away from the deteriorating fundamentals, the technicals also seem to be eroding.

Change and extreme price moves have become contagious lately, possibly worsening the technical picture.

Among the more important concerns I've highlighted recently is that former laggards are leading, which historically is not a signpost of gathering strength.

With depressed stocks leading the rally, there were few new 52-week lows as the S&P 500 approached its peak early last week, but there was also a contraction in new highs. Back in February and March there were 80 to 85 new highs on a daily basis; in the recent rally this fell to 30 new highs, on average.

But change doesn't stop there, as we can witness it in the seemingly successful double bottom in oil prices and in the euro; a potential double top in the U.S. dollar; a reversal to the upside in commodities and 4% to 5% drops in China and German markets last week.

The only thing not changing much has been bond yields -- though U.S. fixed-income yields have been rangebound (not so much in Germany, where the 10-year bund has traded down to a 0.05% yield).

But we might soon see this reverse, too, as a climactic move of higher prices and lower yields in Europe might be in the later stages. This could be very good for my short U.S. bond position, as I suspect an anchor to our rates might just be eliminated.