You're a brave man. Go and break through the lines. And remember, while you're
out there risking your life and limb through shot and shell, we'll be in here
thinking what a sucker you are.
- Groucho Marx in Duck Soup
The US S&P 500 Index shot to over 1,000 on Monday during the day while
other indicators of risk all shrunk. Deconstructing the arguments, one notices
a range of self-contradicting answers that are at the heart of the current
phase, even as everyone blithely ignores the only real answer to the question.
The following is a summary of observations gleaned from the financial media
over the past two weeks. As world asset markets
entered a new phase of expansion, I would suggest readers pour through the
multiple answers that can be found in every major financial media outlet in
dealing with the four questions asked below. The choices are ranked as per
their frequency of occurrence based on my own unscientific survey of media
outlets over the two weeks.
Question one: Why are US stock prices rising?
1. Earnings are better than expected.
2. Inflation is low and other macro-economic data are also better than
3. Investors need to add to their stock positions or risk missing the rally.
4. Low interest rates make dividend income more attractive, and stocks more
Question two: Why are commodity prices rising?
1. Economic growth is better than expected everywhere.
2. Money is being diverted to real assets because people have lost faith in the
US dollar and the euro.
3. Interest rates are low, allowing speculators to buy more.
4. Speculation will be reduced, so everyone is increasing their positions now.
Question three: Why are emerging market (EM) credit spreads improving
1. Commodity prices have risen and will further rise.
2. The International Monetary Fund is making money available.
3. China will do bilateral deals for commodities denominated in yuan to avoid
as much as possible using the US dollar.
4. Market-priced refinancing is now available.
Question four: Why are interest rates expected to remain low?
1. Central banks remain worried about the fragile position of commercial banks.
2. Inflation remains low as rising commodity prices are offset by lower
consumer spending on other items; that is, economic growth is not rebounding
3. Emerging market countries will continue to buy the debt issued by Western
countries only if low interest rates can "guarantee" them no alternatives.
4. It's the only way for current heads of the world's major central banks to
keep their jobs.
I would suggest a quick repeat reading of the answers before proceeding to the
Looking through the maze
In this section, let us examine the various alternatives that suggest
significant logical inconsistencies, factual errors or plain bad math. Readers
will have noticed most of it, but here are a few ideas anyway.
First fiction: Earnings are better than expected. By far the
biggest propellant of equity valuations is the notion that share prices deserve
to go up because companies' earnings "beat" analyst expectations. This raises a
serious intellectual question of why any investor would even bother thinking
about the equity analysts who failed to say anything useful about the stock
markets from 2005 to 2007, and then consistently lagged the market through the
course of 2008.
That aside, readers should probably appreciate some back-to-basics here: say
that a company made $1 per share annualized in 2005 and traded at a multiple of
15x, that is at $15 per share. Then it lost money in its "investment" portfolio
in 2007 and barely avoided bankruptcy in 2008. This company, whose shares now
trade close to $10 after the rebound in the second quarter, was widely expected
to make $0.40 per share in 2009, but now appears to be on track to make $0.50.
So now, what should be the correct price of the share: 15 times 0.5 gives
$7.50, which is 25% off the current price of $10; but instead, the factoid that
it did better than "analyst expectations" has sent the share price to $12. This
level is 24 times earnings. Why is that sensible for any investor? So the
answer to this paradigm is simply that current stock prices already discount
the recovery of earnings up until 2020 in most cases, which leaves little or no
room for error.
Second fiction: Index herding makes sense. One of the more
frequent comments I have seen and heard over the past few months is that
investors must buy stocks now because if they "miss" the index rally, there can
be no jumping back on the bandwagon at a later date.
This is wrong in numerous ways, but the most obvious is that buying into
individual stocks because they are "beating analyst expectations" as in the
example above doesn't mean that investors can be protected from future
disappointments. The idea of using exchange-traded funds (ETFs) to reduce
idiosyncratic risk and increase systemic risk is also a poor one because the
survivorship bias of American indices is rarely captured by ETFs.
For example, a number of failing companies such as financial and automotive
companies are replaced by those with higher stock prices. While this keeps
index base prices constant, it actually costs investors substantially more by
the losses on failing companies and the rally they miss on the new additions
because they are added to indices later on.
Basic math failures: What is good news anyway? Last week,
financial media reported that the contraction of the US economy by 1% was "good
news" because economists surveyed had expected a worse figure of contraction,
Use basic math and keep in mind the fact that previous figures were also
corrected: if - as Bill King writes in the "King Report" - Q4 08 gross domestic
product (GDP) was 100 units, and Q1 09 was reported at minus 5.5% and Q2 09 GDP
was expected to be minus 1.5%, the expectation was for GDP of 100 units minus
5.5%, or 94.5 units, minus 1.5%, or 93.08 units. But, with the revision of Q1
09 GDP to minus 6.4%, the Q1 GDP units become 100 minus 6.4%, or 93.6 units. So
Q2 is minus 1%, or 92.664 units. In other words, the figures were worse, not
better, than expected. 
Yet, read all the financial media headlines from last week and I almost dare
you to find someone who did the above calculation to arrive at what is
effectively a fairly simple conclusion. Really.
Contradictions abound (1):Inflation and the path of interest
rates. Stock markets are assuming that interest rates will remain low, but this
contradicts the most obvious assumption on the other side, namely that economic
growth will improve enough to warrant earnings growth.
Central banks assume that inflationary pressure will remain low and yet stock
prices for commodity-based companies have recently reached all-time highs.
Cyclical companies have seen stock prices rebound, and yet the most important
argument for central banks to restrain interest rates is that consumption has
not edged higher in either Europe or the United States. The rise in stock
prices of emerging market stocks - the best performers over the past 100 days -
also belies the notions held widely by the Group of Seven central banks; the
same is true for credit spreads of EM countries.
Contradictions abound (2):The role of the US dollar. One of the
key constants for markets these days is that falling values of the US dollar
correlate to higher stock prices and vice versa, in what is effectively a
Mundellian portfolio rebalancing (named after Robert Mundell, the Nobel
laureate). This is also the reason that interest rates on US government debt
haven't skyrocketed on the back of the significant increase in spending being
The problem is that, alongside, we have seen the expanded use of bilateral
currency agreements by the likes of China, Iran and Latin American countries,
effectively bypassing the US dollar. Increased use of such facilities dent the
longer-term prospects of the US dollar and make the argument of portfolio
rebalancing suspect for stocks.
To paraphrase the great Sherlock Holmes, whatever remains after one has removed
all other possibilities, however improbable it may seem, is the truth. In this
situation, the option that hasn't been explained away is the vast horde of
money that has been given to banks and other financial institutions globally by
central banks since the great loosening of credit began over the course of
In effect, the only answer for rising market values for risk assets is
that there is money chasing these assets - be they apartments in Shanghai or
equities in New York. If there is one thing everyone has learned since 2007, it
is that the single-best path to economic ruin is to buy something because (and
only because) it is being chased by fiat liquidity.
Health warning: As with all my articles on stock markets, this one too
carries the standard health warning. The aforesaid should not be relied on as
investment advice, readers must consult their financial advisors or use their
Note: 1. This paragraph has been corrected to identify Bill King's "The King
Report" as the source, inadvertently omitted from the original. Our apologies.