The Day Ahead: A Market of Fairytales

 | Jul 22, 2013 | 8:30 AM EDT
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Apologies to mom and dad, but I don't recollect them reading to me as a little kid. Surely they did as a child's brain is formed by their first heroes, mom and dad, and I was definitely programmed somewhere along the way.

Assuming they did read to me, it was probably those dumb (sorry, still sharp-tongued after a busy earnings season start) fairytales meant to spur creative thoughts as opposed to the Wall Street Journal or Barron's (which I will read to my kids) that would bring knowledge of finance at a tender age.

In the mold of a classic fairytale, I believe the current market, with its sexy-sounding new highs and approaching fat financial services January bonuses, is a giant made-up story. There is no truth in stock valuations, just monetary crack running through the algorithms programmed by Harvard alum. The hooks that make this story fascinating include:

  1. Companies "organic" sales are largely missing estimates but earnings are beating, and that is viewed as fine and dandy. Huh? To the bulls, we are in the early innings of paper wealth (stock and home prices) feeding confidence on the part of small, medium, and large business that in turn propels the global economy.
  2. Large-cap tech, namely Microsoft (MFST) and Google (GOOG), but also a few semiconductors, stink up the joint with their earnings. That is perceived as firm-specific, however, not an indictment on the global economy. Hence, other plays in the NASDAQ, as well as in the S&P 500 and Dow, ignore what would in normal circumstances be considered a red flag worth reducing exposure to stocks.
  3. Mr. Market suspects companies continue to sit on unproductive areas of their operations that could drive shareholder value if exited. Essentially, the market expects companies to be in perpetual restructuring mode to boost earnings. It is forgotten that there are only so many structural costs left to be removed post-recession without aspects of other business segments being harmed.
  4. Bottom line: There are no expectations of the Fed reducing its monthly bond buying -- this year or next -- priced into stocks. Investors are back to the mindset of riding the donkey until it shows initial signs of dropping dead.

Call me an old soul, but I still watch valuations assigned to companies, holding out hope they will eventually matter more than a comment from a Fed dove or a hawk. In the pursuit of reigniting interest in stuff learned in three-hour college classes, here are two somewhat disturbing stock valuations that should raise a caution flag:

  • Trailing price to sales ratio (S&P 500): 1.55x, nearing the highest quarterly level of 1.77x achieved in December 2000. From December 4, 2000 to December 4, 2001, the S&P 500 lost 13.6%.
  • Shiller P/E ratio (S&P 500): 24.68x, up for seven straight months, and the highest since December 2007 (25.95x). From November 30, 2007 to December 1, 2008, the S&P 500 lost 44.89%.

Yes, I am aware circumstances today are different compared with both of those periods (internet bust, leverage bust). However, the point is that when valuations appreciate to a certain exuberant level, it reflects Mr. Market failing to price in future risks to corporate fundamentals. In this case, that would be the risk from higher interest rates in a post QE world.

What I am Watching/Seeing

  • I'd rather eat a bowl of poisonous insects than recommend Netflix into earnings. Sorry, I am willing to watch this one zoom higher on pure ridiculousness than comprise my investing principles. 
  • Two early earnings season themes: (1) Europe has stabilized at levels worse than company planning heading into 2013; and (2) not many mentions of business trends being impacted at the start of the third quarter of 2013 from the recent rises in rates.
  • Wonder if United Parcel Service (UPS) goes kitchen sink with its earnings guidance and, if so, the market's reaction.
  • First earnings calls for Lumber Liquidators (LL), Owens Corning (OC), Ryland (B), and Pulte (PHM) this with rates not at all-time lows.

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