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Not All That It Seems

Submitted by Lance Roberts of STA Wealth Management,

Once again the world awaits the Janet Yellen’s post-FOMC meeting press conference. It is almost like the old “Batman” series with Adam West when they would get to the end of the show and leave you with a “cliffhanger:”

“It’s a questionably unquestionable situation…
Are the markets prepared for a shocking answer…
Will Janet Yellen announce the final end to QE? Or electrify the bulls with more accommodation?
Can Yellen’s eloquent elocution energize the markets…or will she magnetize the bears?
Tune in next time Fed fans…Same Fed time…Same Fed channel”

While we wait in breathless anticipation for the next clue, I do find it interesting there is a rising belief that things have returned to some level of normalcy. As I noted yesterday, the bullish mantra is alive and well, and analysts have all turned their eyes skyward with price targets reaching as high as 2800 for the S&P 500 as noted by Jeffrey Saut at Raymond James:

Since 1989 the S&P 500’s earnings have grown by 6.15% annually. Extrapolating that into 2020 implies earnings of $183.36 (see chart on the next page). Using the historical median P/E ratio of 15.5x yields a price target of 2842 in 2020.

While the technical trends remain firmly intact, which confirms the bullish trend and encourages portfolios to be more heavily tilted towards equities at the current time, there are certainly some underlying issues that are concerning. Here are a couple worth noting.

Artificial Drivers

According to the Wall Street Journal:

“Companies are buying their own shares at the briskest clip since the financial crisis, helping fuel a stock rally amid a broad trading slowdown. Corporations bought back $338.3 billion of stock in the first half of the year, the most for any six-month period since 2007, according to research firm Birinyi Associates. Through August, 740 firms have authorized repurchase programs, the most since 2008."

"The growth in buybacks comes as overall stock-market volume has slumped, helping magnify the impact of repurchases. In mid-August, about 25% of non-electronic trades executed at Goldman Sachs Group Inc., excluding the small, automated, rapid-fire trades that have come to dominate the market, involved companies buying back shares. That is more than twice the long-run trend, according to a person familiar with the matter.

 

Companies with the largest buyback programs by dollar value have outperformed the broader market by 20% since 2008, according to an analysis by Barclays.”

This is something that I addressed a while back in “4 Tools Of Corporate Profitability.” While analysts have ballyhooed over surging corporate profits, they have come at a great expense to the average worker. Those profits, driven initially by massive cost cutting and then stock buy backs, are artificial in nature and why prosperity for the bottom 80% of the economy has remained elusive.

[Note: While corporate profit “margins” rose in the second quarter to new all-time highs, it is interesting to note that corporate profits did NOT.]

The primary issue with both cost cutting and share repurchases is that they are both “finite” in nature. With the ability to cut costs primarily exhausted and share repurchases showing signs of slowing; the primary question for market bulls will be the driver for profit margins in the months ahead? If you were hoping for global growth, you might be a disappointed.

China and Europe Stumble

It is important to note that roughly 40% of domestic corporate profits are derived from the major global trading partners of Japan, China and the Eurozone. It should not be surprising, particularly in today’s globally interlinked economies, that no country can remain an “island” indefinitely. Yet, it is currently believed the the U.S. can remain "decoupled" from the rest of the world.

From Business Insider:

“Let's do a quick fly-around of all the disappointing metrics.

  • Analysts expected industrial production to rise 8.8%, but it came in at 6.9%. That's down from 9.0% print in July.
  • Retail sales rose 11.9% instead of 12.1% as expected and 12.2% in July.
  • Fixed-asset investment was up 16.5% versus 16.9% expected and 17.0% previously.

All of this spells trouble, and here's some more: Housing sales were 11% year over year through January to August, versus a 10.5% drop in the first seven months of the year. According to Bloomberg economist Tom Orlik, that slowing in the housing market has been the main driver of all of this discontent.”

More importantly, according to Reuters:

“China's foreign direct investment fell to a low not seen in at least 2-1/2 years in August, underscoring the challenges to growth facing the world's second-biggest economy.

 

The weak investment data came as China's economic growth appears to be hitting a soft patch after a bounce in June, with indicators ranging from imports to industrial output and investment all pointing to sluggish activity.”

Considering that China is a large user of domestic exports, and a large provider of imports (particularly for you Apple product iFans), the weakness underscores real global economic activity.

However, it is not just China that is struggling but the Eurozone as well. The Eurozone is the single largest trading partner of the U.S., so it is very important to keep an eye on what is happening there. France, Italy and Spain, among others, have been struggling ever since the financial crisis, however, Germany has been a strong leader and the primary support to Eurozone’s stability.

It now appears that Germany’s “Wirtschaftswunder,” or economic miracle, is coming to an end, via Reuters:

“In recent weeks, the economy that proud German politicians have taken to describing as a ‘growth locomotive’ and ‘stability anchor’ for Europe, has been hit by a barrage of bad news that has surprised even the most ardent Germany skeptics.

 

The big shocker came on Thursday, when the Federal Statistics Office revealed that gross domestic product (GDP) had contracted by 0.2 percent in the second quarter.”

Dislocations between the U.S. economy and that of the Eurozone have occurred in the past but did not last long.

Therefore, either the Eurozone will find the source of a strong economic rebound or the U.S. is going to see slower growth in the months ahead. Currently, it is the latter that is most probable.

The Extinction Of Bears

Despite evidence that global weakness is mounting, the bullishness on Wall Street is at record levels.

As I wrote last week:

"It is a bad sign for the market when all the bears give up. If no-one is left to be converted, it usually means no-one is left to buy.” - Pater Tenebrarum

That quote got me thinking about the dearth of bearish views that are currently prevalent in the market. The chart below shows the monthly level of bearish outlooks according to the Investors Intelligence survey.

The extraordinarily low level of "bearish" outlooks combined with extreme levels of complacency within the financial markets has historically been a "poor cocktail" for future investment success. 

It is an interesting time in which we live. The financial media has no concern of negative outcomes, Wall Street has growth priced in that has never occurred in history, and there is NO expectation of a recession built into any forward assumptions. We have indeed discovered financial “Utopia,” or at least that is what is currently believed. I can only conclude with quote from Benjamin Graham via John Hussman:

“During the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks… The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.

 

An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”  -  Benjamin Graham & David L. Dodd, Security Analysis, 1934