AlwaysLook at the Bright Side of Life

Investors are often compared to a school of fish.
Though fish do not have a leader, they swim together in unison.
And suddenly, with no apparent reason, they all turn on a dime.
Then, swimming at the same speed and with the same commitment to the group, they all move in the opposite direction.

Sudden mood swings in the markets are notoriously difficult to time.
But one thing will inevitably cause them to happen – bad fundamentals.
One other thing seems constant too – investors will ignore them as long as possible.
Do not pay attention to old timers who tell you markets do not like uncertainty.
It ain’t so.
What markets do not like is Cassandras.
Cassandras are party poopers.

However, facts die hard.
There is no recovery.
There never was one.
As our President would say: make no mistake about it.
The day of reckoning is coming.
The smoke will dissipate and the mirrors will be shattered.

Equity markets bottomed in March 2009 as the US embarked on the first quantitative easing program.
The world followed suit, especially our friends in China.
By the end of this money printing binge, in April 2010, markets became nervous.
What now?
A flash crash and a short summer gloom later, SuperBen was back.
He went to Jackson Hole and sent a clear signal to the markets.
QE 2 was born.
The wealth effect was coming back and one was not to miss it.
Investors obliged.

The Middle East turmoil, the blowing up of one European country after another, retail sales’ collapse in the UK, fears of a municipal bond crisis in the US, an earthquake followed by a tsunami and a nuclear disaster in Japan – that small and irrelevant economy – the impending end of the QEs, a looming shutdown of Washington, trillion dollar deficits as far as the eye can see, stubbornly high unemployment rates, a double dip in the US housing market, an announced fiscal tightening in mature economies, interest rate hikes in the emerging markets and in Euroland, a housing bubble in China, a once-in-a-life time commodity boom?
None of this had any lasting effect on investors’ optimism.
Not even Brent at $125.

Look at the bright side of life.
Investors’ sentiment hit an all time high last month.
According to one survey, the bears accounted for only 15.7% of all investors.

And yet where is the promised growth?
Official figures show a bounce from 2.6% GDP growth before QE2 to an eye popping 3.1% in Q4.
In the first quarter of 2011, it was supposed to accelerate even further.
Every economist and his his dog was telling us the recovery was taking hold.
GDP was confidently projected to be 4% in Q1.
The printing press was working miracles.
That is until they all started revising Q1 GDP numbers down.
2% now looks optimistic.
What now?
QE 3?

What we did get, however, is inflation.
Maybe a transitory one, but inflation nonetheless.
This is very palpable to the few of us who do not buy a new house every week.
If it were not for the retracement of housing prices, CPI would not be at 2.1%.
Using pre-1980’s measurements, it actually stands at 10%.
Not an insignificant difference, which shines a different light on today’s cost of money.
Similarly, if measured properly, unemployment would be twice the reported number.
All this is a joke and makes one wish for Chinese style transparency.
But investors choose to ignore it.
As long as possible.

The combination of low growth and inflation used to be called stagflation.
The handful readers of this report know I have repeatedly been warning about the inevitability of it.
It is here now at a time the stock markets have reached dangerously high valuations thanks to Bernanke’s wealth effect.

Two long term measures are clearly sending warning signals.
The Q ratio, which measures stock prices relative to net asset replacement cost, and the CAPE ratio, which looks at prices relative to inflation adjusted trailing 10 year earnings, both have reached levels seen only in periods preceding market crashes.
Think 1929, October 1987 or the end of 1999.

Of course, valuation is in the eye of the beholder.
If a conservative method of valuation does not give the bulls satisfaction, they always come up with better ratios.
Market peaks typically bring the best out of analysts’ creative side.
Just consider this recent recommendation from a tier-one Wall Street firm:
“While our 2014 (!!) forecasts appear no more than reasonable, multiples tend to remain high throughout the upward part of the (hotel) cycle, and we do not see this as a barrier to further stock price performance.”
If it looks expensive, just add three years of explosive earnings growth.
Et voila. Now it’s cheap.

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