Back to Reality: Reflections on the Latest Market Moves
It’s amusing coming back to the keyboard after two plus weeks of absence and seeing how little the big picture story has changed. Since this is my first post in quite some time, I warn in advance that it will be slightly longer than my usual post. Getting married is one of those big life events that lends itself to healthy doses of self-reflection on the past and dreaming about the future. Combine the event-based catalyst with the longest vacation in my post-schooling career and you get yet more deeply philosophical abstract thought. In addition to taking this time off, I figured it would be a good time to “cut the cord” and unplug from the digital world altogether. Sometimes until you unplug for a week or two it’s impossible to realize just how silly the day-to-day dramatization of the 24-hour news cycle clouds the big picture perspective.
Case in point is yesterday’s announcement of a lawsuit against Bank of America (NYSE: BAC). The headlines would have you believe two things: first, the New York branch of the Federal Reserve Bank itself is suing Bank of America, and second, Bank of America faces $47 billion in losses from this lawsuit. Let’s take a quick look at each of those claims to highlight just how sensationally absurd the headlines manipulate the real life implications of an event. While the NY Fed is a named party in the lawsuit against Bank of America, this is not an example of the NY Fed conducting its own individual inquiry in order to attack one of our nation’s largest banks as the headlines would have you believe. Rather, the NY Fed, on behalf of the parts of Bear Stearns that it now owns in the Maiden Lane holding company is suing Bank of America. It’s pretty simple in the end.
The second part is perhaps the most laughable. This is America, home of the big ticket lawsuit whereby the headline number is NEVER the end amount. While $47 billion sounds like a large sum (and it certainly is), I can assure you with 100% certainty that there is no way Bank of America will be held liable for anywhere near that sum. More realistically, when big entities tango in the arena of the law, the end result is a settlement rather than a judicial proceeding and the settlement is always for far less than the claimed amount. After the plaintiff’s attorney stated her case on CNBC, one of the deca-panelists surprisingly stated that “she really is coming after Bank of America on this one.” OF COURSE she is! As the plaintiff’s attorney it is not only her job, but also her duty to “zealously represent” their interests. The word “zealous”—which the dictionary defines as “filled with or inspired by intense enthusiasm”— is there for a reason.
Aside for this foreclosure “crisis” that emerged over recent days, the two biggest stories during my hiatus are the stock market’s continued rally and the dollar’s continued decline. These are both some real happenings that deserve attention.
The dollar talk is kind of funny to me right now. From mid-April to early June all the rage was the dollar surge. While the economic outlook, particularly in Europe, took a turn for the worse, the dollar benefited as the “flight to safety” trade. Just one quarter later people are kissing the dollar bye bye. I don’t even think people remember the “Bond Bubble” talk from two months ago. As I have been trying to assert for some time now, things in reality are not always black and white. The rhetoric has gotten far too extreme against the dollar to the point where no one even remembers or looks back upon the surge that preceded the drop and nowhere in my newsfeed over the last two weeks did I even see mention of the move in Treasuries.
These days, people assert that the market is rallying BECAUSE of the dollar’s drop. Although correlation is particularly high between the dollar’s drop and the market’s rally, the causation between the two simultaneous events, in my opinion, is grossly misattributed. The dollar’s drop and the corresponding rise in equities are both the result of the end of the flight to safety and the willingness of market participants to once again put money to work. Stated another way, the dollar’s drop is not causing the rally in equities. There is a common thread between the two moves, but there is not the causation element. With that being said, it is certainly possible for both the market and the dollar to move in tandem moving forward. Whether that happens or not is a different question, but way too much is being made of the connection in the short-term (check out Brandon’s take on the dollar from a week ago, I agree with many of his points).
Brief Digression: At this point in time, these moves are a reflection of the Federal Reserve Bank’s openness to Quantitative Easing 2.0. I got to reflecting on QE 2.0 a little bit while I was gone. There are two general positions with regard to the present state of Fed Policy: some think that QE 2.0 should already be underway, while others think that nothing more needs to be done on the monetary policy front. As things stand now, the Fed has expressed a willingness to embark on QE 2.0 but has yet to do anything. In my reflective time, I have concluded that rather than seeing the Fed’s statement as an openness to QE 2.0 we should all interpret the message from Bernanke as a “soft” inflation target. As investors, we should think about it thusly: in the event that inflation remains below the targeted 2% level, the Fed will continue to pursue aggressive monetary policy. Much like the “extended period” line that continues to reappear, we have yet another example of the Bernanke Fed conducting policy via language.
Sometimes we lose track of why people actually own stocks. No one buys a stock because the dollar is going down. Institutional money doesn’t buy stocks solely for equity appreciation. Real money doesn’t care all that much about what lines on charts are telling them. Sure it may be a guideline to many, but it’s by no means a tell-all. Before I went away, my next to last article asked whether “Robert Prechter knows that stocks are interests in real companies?” And I led with a quote from Seth Klarman that’s worth repeating:
“It is critical for an investor to understand that securities aren’t what most people think they are. They aren’t pieces of paper that trade, blips on a screen up and down, ticker tapes that you follow on CNBC. Investing is buying a fractional interest in a business….”
This fact too often gets lost. People buy stocks to own a portion of the cash flows that a company generates. More than any other factor, this key fact of the stock market is something that almost all seriously successful investors over the long run focus on. Stocks follow the direction of earnings, generally speaking. The importance of this fact manifests itself in two significant ways right now: first and foremost is that earnings growth has continued even as the growth rate in GDP has slowed down in the second half of 2010, and second, although the broader economy can run into some headwinds, there remain some very important secular trends that will continue irregardless of the macroeconomy. Investors will continue to want to own the companies returning money to shareholders either via earnings growth, dividends or share buybacks.
The movement in the stock market over the past two months, rather than indicating a correlative move higher on behalf of the dollar, is indicative of the healthy reorganization of our economy following years of excess in the financial sector. When I first started writing for the WSCS, I asked the question “can the market rally without the financials?” Over the course of the past month we received a clear-cut answer in the form of a resounding YES WE CAN! In the last week, the tech-heavy NASDAQ 100 Index is making 52-week highs, while the financials (as represented by XLF) are wallowing a mere 9% above their 52-week low and 15% below their 52-week highs.
This is exactly what I would like to see for signs of a sustainable and lasting recovery. Through much of the 2000s, the financial sector was way too bloated for a healthy economy and the Great Recession was driven by the collapse of our financial system, which subsequently brought down the real economy. Now that we have some sort of stability in our credit markets, the good companies continue to grow with financial obstacles. It’s important to make some distinctions here. While many individuals are struggling, and the lingering impact of the recession is both severe and very real, companies outside the financial sector have their cleanest balance sheets and leanest operations in decades. Additionally growth in emerging markets continues to be a strong catalyst for earnings growth at American multinationals. These trends bode very well for our equities.
The leaders in this maturing rally are our country’s most innovative and cutting edge companies. Many of these companies excelled during the last few years and their earnings and price levels are resultantly well above their pre-recession levels. Yet despite this aggressive rally, many of these growth companies are trading at multiples well below recent historical trend levels. The argument remains that for the long run equities are in fact cheap. Just today, Bill Miller said that now is one of the best times to buy stocks since the early 1980s. He clearly recognizes that earnings have been rising while multiples have been compressing while interest rates are at once-in-a-lifetime low levels. With even modest forward growth and a little multiple expansion, the stage is set for long-term ownership in equities.