The Day Ahead: A Reality Check on the Rally

 | Jan 18, 2013 | 8:30 AM EST
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Technically speaking, owning a single share is supposed to mean being a part owner in a publicly traded company. When was the last time you thought like that? Better still, have you ever thought like that? Personally, I have grown rather jaded on the usefulness of old investment principles.

Imagine that an investor had no access to anything that could detract his or her analytical attention and received only hand-delivered updates on owned stocks and the macro picture. In that world, I'd venture to say that the market would not be where it presentably resides. What has occurred is a complete and utter detachment from sound investing, and in its place is an excessive focus on arbitrary numbers concocted by machines that were programmed by humans who wield natural biases.

Imagine yourself being locked in a room in January 2012 with an assistant who passed along news on individual companies and on the macro situation, received via mail. In the week ended Jan. 20, 2013, the following would probably be on the notepad:

  • Revenues are in fact growing, but at the expense of gross margins. Companies seem to have this infatuation with boosting revenue by way of competitive prices on newly made, cheaper-quality products, with the goal of driving gross profit dollars. This strategy is unhealthy for the long-term standing of the business. Companies are essentially generating lower-quality earnings, and the market wants the investor to be OK with that (in other words, to pay up to own it).
  • Thus far in earnings season, companies have continued their mindfulness on operating expenses. In digging down into the reports, it's as if companies are living for the now and forgetting about the future (who cares, as the current CEO is gone in five years, right?). The market loves this, as earnings and cash flow are artificially propped, and stocks could majestically rise to the moon through expansion of the price-to-earnings multiple. Caution: Even if there is zero fiscal drag in 2013, many, many companies are not offering investors a sustainable stream of earnings. And while we are going buck-wild, chew on this: Why do CFOs continue to manage cash as if it was their own? There is a fear of cash going bye-bye in the future, and this is sending companies to the debt markets at 8% when interest rates are normalized.

Perhaps I am being completely naive in that the intricacies of investing, such as a lethal combination of due diligence and common sense, actually matter amid the proliferation of server farms. Each day of this week, I have become incrementally more worried about the market. I smell the irrational exuberance in the air. I am having nightmares about a singular overnight event happening that is the ultimate sell signal, but it goes overlooked until there is a 5% pullback (at which time the bulls say losing 5% is "healthy" and "overdue"). These are undoubtedly things I did not experience earlier this month.

Luckily, I haven't said, "Sell it all today and walk away." Rallies of this nature feed on their underlying ridiculousness up until a valid worry arrives. Two limp reads on regional manufacturing in January won't cut it, yet. One eye continues to be on the exit, while I keep offering flirty smiles to the bulls to keep them convinced that I remain convinced.

Will the rally continue? Decide for yourself:

  • Why do the financials act as if the next six months will be fundamentally different from the last six months? Financials ran hard into their second-half 2012 re-accelerated earnings reports. I am supportive of the housing recovery thesis, but remember that in addition to growth shifting to more moderate levels (or negative levels for Johnny-come-lately shareholders), there is greater uncertainty year over year due to fiscal drag (which is a negative factor as well).
  • The yield curve appears fine.
  • A "rebounding" economic report is unable to the hold the rebound (see the Philly Fed report). This should ultimately breed distrust in the bull case.
  • Holiday-sales misses by retailers are likely to lead to conservative order planning in the first half of 2013. So, are the robust moves in transports absolutely warranted?  My view is that forward P/E multiples on United Parcel Service (UPS), Ryder (R) and JB Hunt (JBHT), the main truckers I track, are too inflated, on the basis of the assumption earnings will grow into the valuations. No clue what that means? Drop me an email.
  • "Growth" companies are nowhere near sustaining their growth rates (see Chipotle Mexican Grill (CMG) and lululemon athletica (LULU)).
  • Count the number of categories in the consumer price index report that notched price declines despite uber-low interest rates and the mega-powerful stock rally. Is that congruent with anything remotely bullish?
  • The debt ceiling will be raised. After that event, however, are we fully out of the woods to the extent that stocks currently project? If so, then the Fed will drain some of its accommodation from the system later in 2013 (as those Fed minutes suggested). Are stocks pricing in that probability? 

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