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Today's Investors Aren't Buying the Dip, They're Buying the Flip

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Investors aren't allocating capital to investments in companies; they are trying to exploit prices at somebody else's expense.

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When interest rates shot higher in May and June with the backdrop of equities going parabolic, we were told stories of a great rotation out of fixed income and into stocks because growth was accelerating. Markets were simply discounting an improving economy. I was skeptical, and on May 13 in Welcome to the Dark Side of QE: The Yield Curve Adjustment Process I concluded the following:
Don't kid yourself: This rally in stocks has been a function of multiple expansion based on a collapse in credit risk due to a depressed 10-year yield. If the Fed is truly mapping the exit that game is coming to an end. In a rising rate environment, earnings growth should shoulder more of the returns going forward, and in a sub 4.0% nominal GDP world, earnings growth is going to be hard to come by. According to FactSet, Q1 earnings growth has been 3.2% which is in line with Q1 nominal GDP growth of 3.4%. The Bernanke disciples are claiming QE victory with stocks refusing to go down, however his metrics of growth and inflation are decelerating to near the lows of the recovery.

It's now obvious that US stocks were not responding to better earnings or economic growth. Friday's FactSet Earnings Insight reports that with nearly half of the companies in the S&P 500 reporting Q3 earnings, the blended growth rate is 2.3% on revenue growth of 2.0%. Not coincidentally the growth rate of nominal GDP is trending near 3.0%. At the end of the day, companies are going to grow at the rate of nominal GDP, and any excess return you are receiving in multiple expansion today is return you are foregoing tomorrow. The higher it goes, the longer it will take.

There is nothing inherently wrong with multiple expansion, but investors need to know that there's a limit to this market dynamic, and there is no way to quantify what that is. The stock market is dominated by short term traders, not investors. The price action is trying to generate performance for the quarter, the month, the day, and the hour. Momentum trading is about the greater-fool theory. You are buying a business; you are buying a commodity. The pressure to participate in this rally is intense and investors left behind -- professional and retail alike -- are desperate to get exposed.

The buy-the-dip mentality has been rewarded, and investors are comfortable it will continue. But investors today aren't buying the dip -- they are buying the flip. Each buyer is the greater fool hoping there's another fool waiting in line. This can continue for a while, but it can also end tomorrow -- and no one is going to tell you when the music stops.

Twitter: @exantefactor
No positions in stocks mentioned.
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