The global capital-market rally since the March lows was a great trading opportunity, but the rally may have been based on shifting-sentiment (as opposed to structural improvements in the economy). The market was “pricing in” (or hoping for) a quick recovery; even though there was no evidence to suggest clear-&-compelling improvement in GDP, employment, deleveraging consumers, or corporate earnings.
- Yes, the government was able to stop Financial Armageddon; but that’s not the same thing as an improving economy.
- Yes, the US economy is resilient and will recover and prosper in the long-run. But “In the long-run, we’re all dead”, to quote the Nobel Prize winning economist Keynes.
Like the cartoon character that has run off the ledge of the mountain but has not yet noticed the fact that he’s running on thin-air, once equity investors look down it may get ugly.
Neither Borrower, Nor Lender Be
Whether you’re a bull or a bear, we can all agree on the following fundamental-facts:
- Deleveraging Consumers and Businesses. Everyone (except for the government) is tightening their belt and reducing their consumption. Government alone cannot carry the economic load forever, and if consumers (or businesses) don’t quickly step in we may face a double-dip recession. The $64,000 question is: How does the private sector look (or what’s left of it)?
- Unemployment Is Above 9% and Climbing. Unemployment is a lagging-indicator, and historically continues to get worse even if the economy picks up. This bit of bad news is not going to get better anytime soon, even if you think the economy is recovering now!
- Depressed Wages. Many corporations take advantage of high unemployment levels to keep wages down for their existing employees. This makes sense for the firms (the weaker economy justifies lower wage growth) but it has the unintended consequence of reducing the purchasing power of those already employed.
- Demographic Disaster. If consumers are the engine of the US economy, then Baby-Boomers are the turbo-charger; since they make up such a large demographic. But Baby-Boomers are nearing retirement and even if the economy picks up this year they have a lot of saving to do in order to repair the massive damage to their wealth. In short, deleveraging consumers & businesses, unemployment, depressed wages, and fortifying baby-boomers cast doubt on the bulls believe the economy is going to rebound…at least not by the consumer.
- Catch 22. Corporations cannot lead a recovery until banks are healthy. But banks cannot repair their balance sheets until they can lend to consumers that are both financially sound (which they are not), and willing to borrow (which they do not). But if things continue as the current rate (or “improve” only slightly) then banks cannot rebuild their balance sheets because for every item a bank recapitalizes, it faces another default somewhere else (foreclosure, credit cards, etc).
- Government Tapped Out. The resources and credit-worthiness of the US government are almost unlimited. Almost. But there’s only so much the government can borrow before it too must tap-out. Furthermore, if the borrowing becomes too excessive, then the medicine will become worse than the disease. Too much borrow may eventually crowd out private sector borrowing, increase borrowing costs, place a huge burden on taxpayers which reduces future consumption and economic activity, etc.
- Global Economic Decline. The US cannot export itself out of this problem, because the rest of the world is in the same position (if not a lot worse). The BRICs (or any other emerging market) grow largely due to exports and not organic domestic-growth. The OECD nations are all sickly, one worse than the other. Unfortunately, bad economic news has come “not as spies, but as battalions”.
Fear, Greed, & Beauty-Contests
So where is the DOW headed, as we enter Q2 earnings season? In the end, Q2 earnings will not matter. Nor will the mountain of forecasts dissecting it. What matters is how the market responds to Q2 earnings. As a trader, I agree with the Keynesian “beauty contest” rule: to determine winners of a beauty contest look to and anticipate the judge’s decision and don’t bother deciding who you think will win because you think they’re “pretty”. In short, what the market thinks matters, even if you think the market is “wrong”.
The rally off the March lows was based on shifting-sentiment. Fear of losing out on the rally, greed to jump in and make profits, and “pricing in” (or hoping for) a quick recovery. What the market thinks matters, even if you think the market is “wrong”. But the market is also self-correcting…like the cartoon character that has run off the ledge of the mountain, once it realizes its predicament, it will eventually come crashing down (or, “mark to market”).
OOPS, I DID IT AGAIN…I MADE YOU BELIEVE
The things you can always count on are: death, taxes, and whipsaw. Any trader worth his or her salt can attest to the fact that the market throws some wicked sucker punches, or whipsaws. Prior to a major rally, market participants will become convinced that the sky is falling (think fear). Right at a market top, investors and traders will be told that good times are here to last, things are “really different” this time, if you don’t buy now you’ll miss the opportunity of a life-time (think greed), “green shoots”, etc. The cycle repeats itself, ad infinitum.