The Equity Conundrum: Part I

Nothing exemplifies the equity conundrum (yes, there is one here, too) than the dichotomy between the deteriorating fundamental reasons for higher stock prices and the liquidity and leverage machines of unregulated money.

This week, I will touch on four aspects of the equity conundrum beginning today with a look into the deteriorating fundamentals supporting the argument for higher stock prices.

Tuesday will explore the technical analysis justifications of climbing a wall of worry. Wednesday will cover the bottom up approach to investment decision-making and why I believe it is flawed. On Thursday, I conclude with a look at the powerful forces of liquidity and leverage and unregulated money.

Deteriorating Fundamentals

Then…

With each passing week, the data makes clear that the economic climate in the spring of 07 is quite different from that of the fall of 06.

Last fall, inflation was a nagging problem but it was believed by many (not the least of which was the Fed) that it was headed lower. Energy prices had moderated and productivity remained strong. Corporate earnings expectations for 2007 were in the low double digits. The US housing slowdown had begun but there were few signs that it would spread to the overall economy in a serious manner.

Global growth was strong and expectations for the coming year were in the mid single digits, with all of the higher growth coming from emerging market economies. China was showing signs of overheating, but government policies were deemed appropriate and would have the desired effect of reducing excess speculation.

Monetary policies around the world were in a tightening mode. But long rates were showing no signs of concern of inflation.

The geo political environment was in flux, however, as the Republicans lost the Congress and protectionism was a concern but it was mostly talk. Iraq and other regions were in bad shape. Aside from the political consequences in the US, little had changed over the past several years.

And Now…

Contrast each of the above items with where things are today.

Inflation remains stubbornly above acceptable levels. Energy prices are headed higher. Corporate earnings growth have been adjusted downward to single digits, with 1Q07 being set below 4%. Productivity growth has slipped considerably and wage pressures are rising.

Perhaps, the biggest change is in housing, with the sub prime problems and its potential ripple effects on consumer spending. This is a story that has legs.

Monetary policies remain unchanged – tightening even further. Long rates, however, continue their liquidity-induced conundrum suggesting to some that either (a) economic weakness is headed or (b) inflationary concerns are unfounded. Neither is correct for reasons that I will elaborate on in Thursday’s installment.

A careful reading of the Fed suggest that concerns over slow growth and persistent inflation (mild stagflation) are justified and troublesome.

The already poor geo political environment has worsened, most notably with the rise of protectionist actions in the US. If left unchanged, retaliation is certain. And the likelihood is that things will actually get worse. Moreover, the nexus of global growth, monetary policies, interest rates, and geo political risks occurs here. Finally, the recent comments by Chinese Premiere, Wen Jiabao, regarding the “unstable, unbalanced, uncoordinated, and unsustainable” condition of the Chinese economy just adds to uncertainty factor of the emerging market growth phenomenon.

Other geo political risks are also in worse shape with the Middle East tensions threatening to widen as Iran ups the ante.

Finally, back in the US, Republican-minded investors can find little comfort in the chaos that is their party and the mountain of cash being raised by leading Democrats, most notably Darth Vader herself, Hillary Clinton.

Investment Strategy Implications

The fundamental justification for higher stock prices rests in a belief that the overall economic conditions conducive for growth and stability are present and likely to remain so for the foreseeable future. It could be argued that this was the case last fall but not today. The deterioration that has occurred since then is now so severe that, at a very minimum, investors should demand an appropriately higher risk premium for stocks. To accept any fair value arguments is inappropriate and far too risky for my thinking.

Note: Many bulls (both fundamental and technical) would argue that we are in a new phase of the bull market and investment principles like climbing a “wall of worry” are fitting. I disagree and will expand on this in tomorrow’s blog entry.