Bloomberg radio appearance

In case you missed the Tuesday, October 19 appearance on "Taking Stock with Pimm Fox", click here

Seeing Is Not Believing

Confused over this morning’s initial US stock market reaction to the poor employment data? Don’t be. Here’s why:

In the eyes of the cyclical bulls (who currently rule today’s market thinking, with the underperforming momentum lemming hedge funds in tow), the poor employment numbers are a twin win for the following two reasons:

1 – The Fed’s dual mandate includes the goal of full employment. Accordingly, QE2 is headed the economy’s way. This ensures another flood of money thrown at the problem, much (most?) of which will bleed its way into the financial assets.

2 – Today's employment data is the last report before next month's mid term election. Anything that damages the reviled party in power, the Democrats, enhances the chances of a Republican win next month. Gridlock will ensue, something the cyclical bulls believe is good for the economy and markets.

From a corporate profits perspective, third quarter results will be just fine – at to slightly above consensus expectations. This will provide the expectational foundation for future earnings results at consensus expectations at a minimum, which puts the 12 month forward operating earnings outlook for the S&P 500 at or above $84.

With an above average P/E of 17, the future fair value of the S&P 500 is 1428, or 1286 in today’s market.

Seeing Is Not Believing

Other than 3Q10 earnings results, I do not subscribe to any of the above views as presented but offer them as the rationale for this morning’s initial stock market action. That said, the technical analysis deterioration noted over the past weeks (see blog postings below) is unchanged. Unless reversed, a 3 to 5% stock market pullback is likely.

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Dreams of a Cyclical White Knight

And now for some more first order thinking.

At the heart of yesterday’s commentary is the issue of cyclical recoveries morphing into sustainable economic expansions. The argument by the bulls subscribing to this view is that this is precisely what will occur this time as it has every other time before. The virtuous cycle saves the day. This is about as straightforward as it gets. The argument against this thinking is equally straightforward.

When the global macro economic system is hit by an extraordinary event, the post crisis environment is anything but normal and the odds of a cyclical recovery resolving a structural crisis are very long. What is then needed is a structural solution to a structural problem. Examples of this thinking abound (not that the cyclical bulls are listening), with today’s commentary in the FT by Martin Wolf among the most cogent.

The topic of Martin’s commentary may be the emerging currency war with a particular focus on China. The essence of Martin’s commentary is, however, the more important point – structural problems require structural solutions, which in a global economy can only be solved via cooperation between the major global players. Yet, cooperation between the major global players requires leadership. Since the logical country in a position to exhibit that leadership, the US, has as its head a political manager and not a leader, the odds of someone taking the lead toward the necessary cooperative environment for structural change are very long indeed.

The Post Crisis Environment

Crises occur mainly due to structural (systemic) problems. The post crisis environment that ensues is one that rarely resolves itself via the cyclical solution. Yes, cyclical rebounds do improve things for a while but they do not get to the heart of the matter. The structural problems remain and will overwhelm the relatively meager energy of a cyclical bounce. It’s like trying to treat a patient with a life threatening disease with antibiotics. It just doesn’t work.

To use the stock market analogy in the current environment: cyclical bull markets within secular bear markets do not change the reality that the equities are in a secular bear market. Accordingly, cyclical recoveries within a structural (secular) change environment will not resolve the systemic issues at hand.

The bullish rejoinder to this is the muddle-through solution: Things are never so neat and tidy. Stuff happens, things are messy. But, fear not, we will find a way out of this mess. We always have and will do so again. This time is not different.

However, as I argued yesterday, such thinking concludes that this time IS different, for the norm in a post crisis environment is for extraordinary measures to be exerted, which includes fundamental changes in the rules of the game. Therefore, this time is not different as crises do occur and the subsequent environment requiring fundamental change is the norm.

Who will be right? The cyclical-recovery-saves-the-day crowd or the we-need-to-address-the-structural-problems club? Time will tell, which I suspect will be sooner than most think. One thing is for sure, however, someone is going to be real right and the other will be real wrong.

Investment Strategy Implications

My money is with the structural problem club. However, the cyclical dreamers are in control right now. Therefore, as an investor and investment strategist, I cannot act aggressively until the technical analysis signs that the market is ready to embrace the more worrisome view of my club. (Think, the recent vintage tech and real estate bubbles.)

Accordingly, before shifting from the currently cautiously bullish (60 to 90% in equities) posture to neutral (40 to 60% in equities) to outright bearish (<40%) clear technical analysis signs, most notably external and internal divergences, must be evident. At present, as noted last week only the internal divergences are. Therefore, cautiously bullish (the equivalent of driving with one foot on the brake) remains the advisable strategy.

As history teaches us all too well: delusional thinking rooted in old school dogmas can maintain its grip for a very long time.

This Time IS Different

The bulls (not the bears) would have you believe that this time is different.

The root of this view in anchored in the dogma that the cyclical recovery cures all ills as follows:

The cyclical recovery evolves as increased corporate spending on wages and new hires which, along with an increase in emerging economies’ consumer spending, result in a consumer led demand driven sustainable cyclical expansion. Corporate profits rise further enabling the virtuous circle to become engaged.

The sustainable cyclical expansion then helps to alleviate the structural risks to the global economy – e.g. current account imbalances – thereby enabling the financial sector to recover further and move the global economy off government life support.

The financial markets respond with a move more toward normality as rates rise, the dollar stabilizes, gold loses its luster, and equity valuation levels return to above average (>15 times). The combination of higher corporate profits and above average P/E levels drives stock prices back to record highs, which for the S&P 500 means 1548 (18 x $86).

An era of growth and prosperity returns thereby proving that this time is not different; that there will be no new normal (i.e. below average growth and profitability).

Sounds good, doesn’t it? Even plausible, provided one thing – conventional thinking in unconventional times requires a belief that this time IS different.

The Burden of Proof

The bulls would have everyone believe that the burden of proof that this time is different falls on those who say what was no longer works (the old normal) and that the future is a place of great uncertainty (the new normal) with the road ahead a most bumpy one. There’s one problem with this thinking – evolutionary processes to new normals are normal. A purging of the old always occurs and it always leads to a new normal, whatever that new normal may be.

Extrapolating the recent past into the future often becomes a substitute for first order thinking. Be it fighting the last war or blindly accepting corporate earnings guidance, embedded interests conspire to preserve the status quo, which facilitates a blindness to change. And it is change that is normal, not what-worked-before-will-work-again-indefinitely thinking, made all the more illogical given the highly dynamic complex global macro environment the world finds itself in.

In evolution, those that are about to become extinct are the last to notice. The same is true in the social sciences of economics and the markets, where old rules in changed times demand the view that this time is different.

MACD Crossover Imminent

Thus far this year there have been three occasions when MACD crossed over and Momentum turned negative. In each case, the equity markets experienced a meaningful decline (see chart for examples*). We are presently poised for a fourth occasion. Interestingly, October will likely produce lots of conflicting data for both bulls and bears.

For the bulls, earnings season will be more than satisfactory. The aggregate macro economic data produced in the third quarter plus the fact that the confession season has passed with little bad news suggests that earnings will meet or slightly exceed consensus expectations buttressing the bulls' case. On the bear side of the ledger is the emerging traditionally-thinking investor angst that the Republicans won't win either house of Congress, thereby knocking out the gridlock-is-good beam from the bullish structure.

Investment Strategy Implications

Because there are no external divergences, any market pullback in October will likely be minimized with many country/sector/industry/company specific cross currents occurring. Internal divergences on their own are a sufficient reason to lower one's equity exposure somewhat but insufficient to ring the bearish bell too loudly. That time will likely come after the pullback followed by a failed rally followed by the OMG-the-Republicans-didn't-win-either-house introduction to the bear of 2011.

*click image to enlarge

TheStreet.com media appearance

Last Friday's TheStreet.com interview has been published and posted today.

To view the interview, click here

Internal Divergences Emerge. Market Pullback Probable.

As noted in yesterday’s Bloomberg radio segment (see below), internal divergences are beginning to emerge for the first time since early August. The accompanying 3 charts* representing 3 key indices (US, EAFE, and emerging markets) illustrate identical action seen in virtually all indices with price moving up while the key near term internal indicators Momentum declining (a clear divergence) and MACD poised to rollover. Moreover, today’s bounce has lifted the short-term indicator (Slow Stochastic) back into overbought territory.

The net effect of the early August internal divergence was a negative 8% for the S&P 500. With so much enthusiasm behind the current market rally (see yesterday’s blog posting illustrating the record low cash levels of mutual funds and the valuation math supporting the current market, as examples), stocks are now in a much higher risk zone than is generally appreciated.

The saving technical analysis grace is the absence of any external (index to index) divergences. That said, a pullback now followed by a further run to higher highs (courtesy earnings season) may produce the external divergence condition necessary to signal an end to this rally followed by a far more meaningful decline. If no external divergences occur in an ensuing rally, however, then the bulls will rule the roost for a while longer.

*click images to enlarge

Bloomberg radio appearance

In case you missed the Monday appearance on "Taking Stock with Pimm Fox", click here

Media appearance on Bloomberg radio "Taking Stock with Pimm Fox"

Media appearance today on Bloomberg radio program "Taking Stock with Pimm Fox" at 4 PM (eastern).

Prospective talking points:

* There may be an enthusiasm gap in politics but there is certainly not one in the equity markets.
* The September relief rally has morphed into a more confidently bullish mode lifting valuation models well into overvalued territory.
* At to above average P/Es are now embedded in the data.
* Is the current environment average, which therefore justifies an average P/E of 15?
* Do the valuation math:
o current S&P 500 price: 1147
o required return: 11%
o future price (12 months ahead): 1273
o optimistic expected earnings (next 12 months): $86
o future price (1273) divided by exp. earnings ($86) = 15 P/E

Also, re enthusiasm - Cash levels at stock mutual funds are now at their lowest levels in decades. (see accompanying chart - click image to enlarge)

Plus market technicals - internal divergences have begun, no external divergences thus far.
Last time internal divergences occurred (early August), stocks dropped 8%.

Beyond the Sound Bite: An Interview with Simon Johnson

"A fiscal agenda that is sensible and a fiscal message that makes sense has to make banking front and center."
Simon Johnson

The consequences of public policy decisions are front and center in my very informative interview with the coauthor of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown and highly regarded commentator. In the interview we explore many vital issues - too big to fail, shadow banking system, securitization, Basel III, US fiscal debt, Elizabeth Warren.

Beyond the Sound Bite podcast interviews can be found at the Blue Marble Research media blog. To listen to this interview, click here.