Editors note: With this column, we introduce Scott Reamer, who runs Union Tree Capital, a long/short equity hedge fund based in Denver. He welcomes your comments and feedback at Scott@minyanville.com.
It is with a humble pen that I join the Minyanville gang. Humble because of the high regard in which I hold each person in the group. Humble too because of the high regard in which I hold the spirit of their philanthropic mission; for me it hits home in a very personal way. It's an easy mission to embrace.
What is not easy however is talking about the risks in stocks priced at these levels. Taking your profits on the long side and being in cash: no one wants to hear that. What's even harder? Making a case for shorting this market. That's downright crazy. No one shorts a market this strong. Why? Because the pain of shorting a market as strong as this one is deep enough to leave marks.
Despite what some may suggest, shorting stocks is one of the hardest things to do on the planet. Even in bear markets, as we've had, shorting stocks present mechanical, financial, psychological, and economic risks. Look at any of the rallies we've had since the top in 2001: vicious, unrelenting, merciless. Adjectives that would fit snugly over the current post-War rally. It's a hard business, and should be undertaken with the same kind of respect one gives to, say, the ocean. Given that, you can understand then why no one wants to hear the short case. That's precisely the reason, however, you should want to.
There is little doubt that the bulls have taken on an air of self-conscious arrivistes; check any number of statistical sentiment readings or just turn on your TV. Volume, price, breadth, momentum -- all are as strong as they have been in this bear market. Small priced stocks that so exemplified the spirit of the late 1990s are once again batting 1,000. The collective blinders are on: valuations, fundamentals, and macroeconomics don't matter. Liquidity, technicals and sentiment were this rally's placenta. Charts that work, that have "broken out," are perfectly contemporary fixations - like reality TV. But I expect a bull market in seat-finding once this particular music stops.
There are times in this business when understanding the nuances of the macroeconomic environment is more important than understanding the microeconomic ones. This is one of those times. Why? Because CEOs have almost zero visibility about their businesses, a point that, though loudly proclaimed by companies, has been roundly ignored by their investors. It is overall demand that will determine the fates of the S&P 500 companies. Very few will be able to post solid results unless overall demand picks up, so understanding macroeconomics is understanding microeconomics. But here is a grain or two of salt: I am no economist. Further, parsing the dismal science relies heavily on statistics. And like dreams, statistics are a form of wish fulfillment, so we use them with some trepidation. You should consume them with the same.
Déjà vu all over again
The second-half recovery story has once again gripped the Street, though this year its proponents drank more deeply from the spout of optimism. One would think that the Street's appetite for promise and hope would have long since been sated; that the lessons from 2000, from 2001, and from 2002 would have been incorporated into the collective psyche.
But alas, no. It remains to me the single most fascinating aspect of the stock market; the idea that this time is different, the triumph -- again -- of hope over reality. The last three years' spring periods have been buy-the-mystery, sell-the-history events, as the reality of second half economic growth became more clear. Currently, Street economists expect 3.5% GDP growth for the third quarter and 3.7% for the fourth quarter, with 2004 coming in at 3.6%. S&P 500 earnings are expected to come in up 12% in the third quarter of 2003 and up 21% in this year's fourth quarter. Wall of worry? What wall of worry? And though the consensus view was that first quarter earnings were better than expected, it should be noted that earnings growth (12% year-over-year) vastly outperformed revenue growth (1% year-over-year), so demand, as it stands, will not aid in getting to those figures.
Because of the gulf between revenue growth and earnings growth, a reconciliation of sorts would seemingly be in order soon: If the consensus is correct and revenue growth (demand) is about to pickup substantially, that will need to happen in the next quarter or two to maintain current valuations. If revenue growth doesn't come soon, those second-half earnings estimates will need to be revised downward, and valuations will follow suit. We've seen the results of this type of reconciliation before, and it wasn't pretty (layoffs, more cuts in discretionary spending, stock price declines, etc.) At current valuations, this time had better be different or that reconciliation will be even uglier.
Of note from First Call too is the following factoid: If we are indeed emerging from early cycle to mid cycle economic recovery, one would expect small cap earnings to grow faster than large cap earnings (more sensitive to changes in demand fundamentals). That was the case for much of 2002. However, in the first quarter of 2003, earnings growth for small caps was something like 10.7%, with large caps a full 1% above that. Pay close attention to the second quarter for the S&P 500 vs. the S&P 600; it should provide us with more evidence that this economic recovery is unfolding strangely.
Check back tomorrow for part two in this series, a look at the consumer's role and behavior.
And tune in to CNBC at 6:10 EDT today to see Scott Reamer on the Evening Business Center where he will be discussing today's FCC ruling.
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