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Get Shorty, Part Four


Editors note: This is the fourth and final piece in a series. Click here to read part one, part two and part three.

Working off the excess capacity from the bubble, dealing with the cheap labor from China, and the globalization of markets are deflationary forces that the Fed is trying to battle. But here's a lesson in excess capacity on a microeconomic scale: Can you name some goods or services that you simply can't find? Name an area of the economy where there is a shortage of something. You can't (save for tanks, army boots, airport scanners and the like). And that's what's plaguing the economy, not a lack of demand.

There is no doubt, of course, that supply and demand are intricately related. But understanding which of those forces precipitated the problems we now have is a valuable intellectual exercise, not least for what it informs us about potential Fed "solutions" to our current economic malaise.

Deflation is as much -- and perhaps more -- about psychology than it is about price, a point brought into full relief by the tortured statement from the Fed after the most recent Open Market Committee meeting: "The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." Note that only four words separate the adjective "substantial" and "minor." Torture indeed.

But this torture has a point, and that is in service to the psychological element of deflation. It can be powerful once initiated because it tends to self-reinforce. Corporate CFOs have already succumbed to the deflation psychology. That idea came to full recently when this headline came across my Bloomberg screen: "Microsoft Lowers Store Cost for Office Package as Sales Stall." Checking with my sources (I covered Microsoft (MSFT:Nasdaq) as a sell-side analyst for years) I can tell you that Microsoft has never lowered prices before. You should not ignore the optics of a monopoly having to lower prices in order to stimulate demand. That's a powerful economic force.

The Microsoft headline is an important data point arguing that deflation (and the concomitant decrease in pricing power and revenues) is ongoing and important to valuations. There are other macroeconomic issues associated with deflation that would make for a far more sobering (depressing) financial view (it involves derivatives, defaults, and depression). But for my purposes, it's important to understanding the pricing power and thus revenue generating capacity that corporations have. If prices are coming down even slightly, the impact on earnings and cash flow -- particularly after many corporations have cut as much discretionary costs as they already have since 2001 -- could be material. Remember, S&P 500 earnings forecasts are 12% for the third quarter and 20% for the fourth quarter. There must be revenue growth to achieve those. A deflationary environment makes revenue growth very difficult.


An economy is always prone to systemic shocks. But an economy on a knife's edge between growth and contraction is even more so. Terrorism, derivatives, ongoing rapid devaluation of the U.S. dollar, capital flight, debt defaults -- all are much more toxic in a slow or no-growth environment. Todd's focus on the risks that derivatives create is spot on. One could argue that the probability of a derivatives blow up is no greater now than it was two, four or six years ago when they were less sizable, complex, and pervasive (I will gladly take the other side of that argument). But you don't have to agree with Warren Buffet's homily that they are "financial weapons of mass destruction." They worry me because their negative impact would be far greater now than if economic growth was robust. Worse, the conditions for a re-valuation event in the derivatives arena go up markedly when large and liquid markets do things that the vast majority of players aren't prepared for. Worse is when those markets do that unexpected thing quickly. Think of the recent drop in interest rates. Think of the recent drop in the dollar. The adjectives quick and unexpected are entirely apt.

What's Right with the Economy and Stocks?

What's going right also is an important question to ask. Lower interest rates, a vigilant (hyper-vigilant?) and accommodative (hyper-accommodative?) Fed, tighter credit spreads, tax relief, recent breakouts, strong market internals, and a weak dollar helping exports. All of these things are underpinning the confidence that investors have both in a second-half rebound and the stocks most levered to it. But that argument, in addition to being not new, has all the range of a daisy air rifle. Everyone was talking about the war rally. Now that we've had it, everyone is talking about a new bull market. Where's the nuance? Where's the empiricism? Add to that the confusion (seemingly just ours) regarding the breakdown in the previously strong relationships between the dollar, gold, stocks, and treasuries. It's a very confusing time in the markets.

As for credit spreads, Brian Reynolds has had much logic to add to this debate, but we remain unable to come to firm conclusions on the implications of tighter credit spreads. They could have as much to do with risk appetite than with any perception that the economy is moving from early cycle to mid cycle growth. Indeed, record retail fund flows into higher yielding fixed income markets -- some 5% of total high yield assets in the first quarter -- have been a powerful force for the bid side of that market. And if retail investors are stretching for yield in a low rate environment, they may eventually be surprised to know that the high-yield market has a higher correlation to stock returns than to treasury market returns. The counterpoint is that corporates are pricing in balance sheet repair. But, as Rich Bernstein from Merrill Lynch pointed out in April, the measures of balance sheet repair, like debt/equity ratios, interest coverage and quick ratios, for S&P companies don't show any such balance sheet repair. Maybe they will, but again, after all this easing by the Fed and record low rates, I wonder why they haven't already?

The End Game Has not been determined

The broad outlines of the end game -- for the markets, for the economy -- have yet to be delineated. And I'm not smart enough to even guess at what they are. Nor am I a slave to the bear case. But my job is to identify excesses in the relationship between risk and reward in the equity markets. And right now, my work suggests a very high level of risk and a very low level of potential reward. But for all of the market's sturm und drang, we remain at major resistance and are in an overbought state. If this time is indeed different, we'll know on the depth and activity of the pullback and the resulting attempt at these levels again.

Please understand that there will be a time when stocks turn upward for a sustained move without any real evidence of business conditions improving either macro economically or micro economically. That's what stocks do: discount the future. Predicting that move -- buying at the bottom if you will -- can make lots of sense: the upside/downside calculation can argue for purchasing the stock even before business conditions improve measurably. That is, of course, if they are cheap enough to largely discount more bad results. That's a big, and exceedingly important, if.

Caveat Emptor

Having said all of this, I have made many mistakes in running a nearly year-old hedge fund. Some were unique; others, sadly, were more common. Almost all of them resulted from being too eager to short stocks. It has cost both performance and asset withdrawals at a time when I can ill afford either. So take this bearish case with the perspective I hope it provides; despite my efforts to see both sides, I may be biased.

The bull case for stocks from these price levels ignores the valuation, fundamentals, and sentiment extremes that exist. Instead, those sirens -- liquidity and technicals -- remain the buoy to which stocks have tethered themselves. Both have been fantastic. But expecting a whoosh of cash from money market funds and from the bond market "bubble" to make their way quickly into stocks -- powering valuations higher -- is a triumph of hope over experience. Household ownership of stocks has not yet been materially reduced (incredible as that may sound) and bonds make up a historically small percent of household assets.

Understand that such tenuous arguments as on rushing liquidity are entirely necessary to push sentiment and price levels to important extremes and create short opportunities. Optimism and bullishness are infectious. The greater distance between March 12 and SPX 800 we get, the more infectious it becomes. That's entirely reasonable: the tyranny of the present always trumps the breezy forgetfulness of the past. I would also note that almost no one seriously talks about breaking the bear market lows in the SPX. It's a notion as quaint as a handwritten letter. This despite the absence of historic precedence for triple bottoms. Without all of these things, the bear case would be weaker. Much weaker. So take them as the necessary elements to the bear case they are.

That said, whether you are a bull, a trading range advocate, or an outright bear, the latest rally, historic in pace and length, presents an important opportunity. I could cite such arcanum as the bull/bear spread, the number of +1000 tick days, divergences in momentum, price and volume, and any number of oscillators to illustrate the overbought nature of this tape. You almost certainly don't need them; your gut should be churning right now.

How you play it from here, by playing defense with cash or offense with shorts is an individual decision. But a smarter Minyan than me has said that being a seller of overbought stocks at resistance and a buyer of oversold stocks at support is an entirely sensible course of action. Against the backdrop of risks I broadly outlined above, you don't need me to tell you where we are today.
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