Seeking Alpha article, Herb Greenburg, and John Hussman

CPI Numbers Don't Square With Reality - Market To Climb Anyway
Posted on Dec 15th, 2006 with stocks: SPY

Barry Ritholtz submits: My pal Cody wrote a column yesterday titled Reality Check. He wrote: "Nothing drives me crazier than when people point to the current state of the economy and lament it as anything less than a boom." He further laments the parsing of "the macro and microeconomic data for any little validation of their wrong views."

One thing Cody is definitely right about: if you have been anything but long and strong, you've been wrong (investing wise). From a trader's perspective, fighting the tape is always a losing battle. The trend remains up, momentum is positive, seasonal strength is upon us, and the bears and shorts have been vanquished.

But is that a Reality Check? Is accepting the Wall Street and Mutual Fund Buy & Hold sales pitch all that real? Do we really take Government Statistics at face -- and call that a true gauge of reality? Has our reality simply become the 200 day moving average of the markets?

Take today's benign CPI data. Futures exploded on the release, and given this is the 2006's last quadruple witch, the bias will be strongly to the upside (although we should expect a lot of volatility in individual names). The best short term advice remains: Don't Fight the Tape!

But the official data continues to be at odds with reality (not that Traders care a whit about that). The CPI release claims there is almost no inflation, with core CPI up 2.6% (consensus was for 2.7%). But consider what the BLS told us today:

• Food prices fell, as orange juice went to record highs, and corn is up 70% since August, while wheat is near 10 yr highs.

• Medical care rose only 0.2% -- apparently, the recent 20% annual increase has been halted.

• Education prices went down 0.2% -- despite widely reported tuition increases -- primarily caused by a decline in long distance phone service prices (WTF?).

• Commodities ex-food and energy fell 0.4%, just as the CRB industrial metals index went to a record high.

Thanks to Peter Boockvar of Miller Tabak + Co for much of the data here

Bottom line remains that the headline numbers look great -- expect markets to respond positively -- but the reality check is this: these Government BLS numbers simply do not square with reality.

While Investors can recognize this, Traders have no choice but to "ignore reality" and go for the ride. A turret-bound buddy wrote me:

I don't care about the numbers, the economic data, whether Iraq is in a Civil war, if the President gets impeached, who controls congress, what a company does, whether we fall into a recession or if China buys Europe and turns it into a Disney theme park. My world is defined by what I see on my four 20 inch monitors in front of me. Everything else is noise.

That's what is driving the markets. And that's your reality check for the day.
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Is it a brains or a bull market?
Investors shouldn't lose sight that there are two sides to each trade
By Herb Greenberg, MarketWatch
Last Update: 5:25 PM ET Dec 15, 2006



SAN DIEGO (MarketWatch) -- To repeat what I said on "Kudlow & Co." on Thursday night: "It's said you should never argue with a crazy person. I'll add that you should never argue about a crazy market."
And that pretty much describes where we are - in a market that hangs by the thread of oil until it decides the risk of rising oil prices is irrelevant; in a market that hangs by the thread of the latest economic indicator, until it decides that indicator is irrelevant; in a market that one week is enthusiastic about the Fed's likelihood of cutting interest rates and the next week enthusiastic when it looks like a cut is less likely.
This is a market, as I've written previously, that lacks conviction and will fall in a vacuum on the whiff of something unexpected - like aging Karl Wallenda, the most famous of all high-wire walkers, falling to his death from a skywalk in Puerto Rico when the wind shifted in a direction he hadn't expected.
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YRCW ) , a trucker that should have its fingers on the pulse of the economy, says the latter.) Doesn't really matter because, as of today, the market sees both as good.
Not to worry: All that really matters is "global liquidity," a catch-all to explain the inexplicable.
"Unnatural," is the way market strategist Jeff Saut of Raymond James explains this market in his latest missive. "Markets typically go up, correct by 25%, and then re-rally if the are going to trade higher," he writes. "This, ladies and gentlemen, has not been the case recently as the averages have 'unnaturally' vaulted higher without so much as ANY correction."
He further marvels at how the SEC caved in to a New York Stock Exchange petition in mid-October to reduce margin requirements "for an already over-margined hedge fund community. And that 'mysterious surprise' gave the major market indices another leg up (read: re-rally)....Why in the world would one introduce more leverage into an already over-leveraged hedge fund community is a mystery to us!" (And to us!)
What about the value of the market relative to earnings? Everybody says it's cheap. Everybody, that is, but John Hussman, of Hussman Funds, who in his weekly commentary writes that at 18-times earnings the market is into its "third phase" -- the phase, he notes, that Richard Russell of Dow Theory Letters says occurs when stocks "spurt skyward on the hopes and expectations of a continuing rosy future ... The low-priced 'cats and dogs' historically make great moves in this third phase."
Adds Hussman: "To anyone who examines more than one or two decades of market history, even a multiple of 18 is very rich by historical measures, and can't be reconciled simply by reference to interest rates or inflation. On closer inspection, of course, valuations are even more hostile. Over the past three years, profit margins have widened to record levels, which have detached P/E ratios from other fundamental measures - such as price/revenue, price/dividend and price/book ratios. The S&P 500 is currently about double its historical norms on those metrics. That isn't a forecast that stocks have to eliminate that valuation gap, but it certainly does suggest that stocks are priced to deliver unsatisfactorily long-term returns from these prices."
There's no shortage of pundits who would disagree, of course. But that, dear readers, is what makes markets - inverted yields, consumer credit, shaky subprime-mortgages, the weak dollar, uncertain housing, financial leverage and complacency, be damned. Minyanville's Todd Harrison put it best in a column here the other day when he wrote, "For every risk, there is an offsetting reward. And those betting on a year-end ramp would be wise to remember that this is a two-way street." Amen, bro'.

*****

 

Phase Three: The Speculative Blowoff


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Charles H. Dow, who edited the Wall Street Journal a century ago, once observed “It is impossible to tell in advance the length of any primary movement, but the further it goes, the greater the reaction when it comes, hence the more certainty of being able to trade successfully on that reaction… The best way of reading the market is from the standpoint of values. To know values is to comprehend the meaning of movements in the market.”

Dow's successor at the Wall Street Journal was William P. Hamilton, and was also a brilliant observer of the market. Hamilton observed that bull markets generally occur in three phases. As Richard Russell summarizes: “Phase one is the rebound from the depressed conditions of the previous bear market. Here stocks return to known values. In the second and longest phase, shares advance in recognition of improving business and a rising economy. During the third phase they spurt skyward on the hopes and expectations of a continuing rosy future… The low-priced ‘cats and dogs' historically make great moves in this third phase…”

As another follower of Dow, Robert Rhea, once wrote: “the final stage is sometimes recognizable because people then buy stocks simply because they go up, and because other people are buying them.”

With the S&P 500 currently trading at nearly 18 times fresh record earnings, on record profit margins, it seems clear that the current bull market is well into its third phase. To anyone who examines more than one or two decades of market history, even a multiple of 18 is very rich by historical measures, and can't be reconciled simply by reference to interest rates or inflation.

On closer inspection, of course, valuations are even more hostile. Over the past three years, profit margins have widened to record levels, which has detached P/E ratios from other fundamental measures – such as price/revenue, price/dividend, and price/book ratios. The S&P 500 is currently about double its historical norms on those metrics. That isn't a forecast that stocks have to eliminate that valuation gap, but it certainly does suggest that stocks are priced to deliver unsatisfactory long-term returns from these prices.

It bears repeating if profit margins were at normal levels – even on the basis of profit margins that prevailed during the 1990's (indeed, anytime prior to the past 3 years) – the price/earnings ratio of the S&P 500 would currently be nearly 25. Unless investors want to speculate on the notion of a “permanently high plateau” in profit margins, the stock market is strenuously overvalued at present. Neither current earnings nor “forward” earnings should be considered – in themselves – as anything close to robust or reliable metrics of value here.

“Known values”

Our own approach doesn't focus particularly on bull/bear distinctions, because the true state of the market is only observable in hindsight. Instead, our focus is on measurable, observable, objective, and historically testable metrics of valuation and market action.

That said, in hindsight, Hamilton 's three-phase view of bull markets has a reasonable amount of historical support. Generally speaking, the first phase of a bull market begins from valuation levels that are below “known values.” On average, historical bull markets have begun from price/peak-earnings ratios below 11 and generally below 9. A few began at multiples below 7, including the bull markets that began in 1974 and 1982, as well as many of the bull markets in the early 1900's.

Typically, the explosive first-year advance in a bull market has involved a recovery from those very depressed P/E multiples, to “known values” around 11-12 times earnings, on average. So “phase one” in Hamilton 's scheme has generally involved a recovery in valuations from levels that have been identifiably below historical norms. Even with bull runs that began at higher multiples, such as 11 times earnings at the 1990 low, it can still be said that at least part of the early advance represented a rebound toward historical norms of valuation.

Not so for the current bull market, however. As brutal as the market's decline was between 2000 and late 2002 – despite a loss in the S&P 500 of about half and a loss in the Nasdaq of over two-thirds its value – market valuations at the bear market trough never penetrated below historical norms.

To put the 2000 top into perspective, recall that during the late 1990's bull run, the market experienced a series of speculative blowoffs. First, “Buffett-type” large-cap stocks were heavily favored through about 2006, and stocks like Coca Cola traded at hefty premiums to historical norms. Next came the dot-com bubble, but even that was largely over by 1998, as it became clear that profits are generally not secure in an industry where it is costless to compete and customers have no particular loyalty. Though both of those blowoffs easily qualified as “stage three” advances, the tech-stock bubble from late-1998 through early 2000 was by far the most irresponsible in that even many professional analysts, who should have known better, lost all sense of valuation and history.

If the sort of psychosis we observed in 2000 is our new metric for what constitutes risk, and stocks are still safe (as many chirping analysts seem to imply) because we're not at that extreme yet, then investors are doomed to spend the future the way they've spent the past 8 years or so – with stocks going nowhere, and lagging risk-free T-bills over the long-term (albeit alternating between exciting gains and horrifying losses, or vice-versa, with nothing to show for the round-trip).

At present, stocks are dangerously beyond “known values,” unless the values observed during the late-1990's bubble are the ones investors really care to know.

 

Speculative blowoffs

Given the overwhelming historical evidence that profit margins normalize over time, long-term investors should build that expectation into the prices that they pay for stocks, which after all, are nothing but a claim on a stream of future cash flows. A market P/E of nearly 25, on the basis of normalized profit margins, doesn't allow any margin of safety.

Still, we have to recognize, as Richard Russell once wrote, that “it is not history, facts, or intelligence that guide most investors through the final phases of a bull market; it is hopes and wishes.”

On that basis, it's not clear that the current speculative blowoff is over, or doomed to end in short order, so long as there are dangling strands of hope. Though the Strategic Growth Fund is well-hedged, we continue to hold a moderate position in index call options (increasing that position after short-term weakness, and clipping it somewhat after short-term market strength). I expect that we'll maintain that position until deteriorating internal market action makes it clear that investors have become more skittish toward risk.

Meanwhile, it's essential to recognize where the market is in terms of valuations, and in the context of the full market cycle. To repeat Charles Dow, “To know values is to understand the meaning of movements in the market.”

Among the current signs that the market is engaged in a speculative blowoff, investment advisory bullishness is running near 60%, which Investors Intelligence notes is about the level where historical bull markets have ended. As for the “smart money,” corporate insiders are aggressively liquidating stock, at a rate of over 7 shares sold for each share purchased, according to the latest readings from Vickers. Meanwhile, the new issues market is booming, and low-quality stocks (on the basis of S&P's quality rankings) have for months dominated an otherwise dwindling group of market leaders.

Though CNBC briefly seemed professional in the wake of the 2000-2002 market plunge, airing short conversational spots where the anchors emphasized journalistic responsibility, that tenor has now been replaced by carnival-barking shows like “Mad Money,” complete with its lightning round, featuring a shrill whine of irresponsible speculative “plays” backed by death-metal guitar music, and “Fast Money” promoted by spots that promise, for example, “Tonight, the boys get down and dirty with a hot commodity...” I wish I was making this up.

All of that said, keep in mind that even the knowledge that stocks are in a speculative blowoff isn't a very useful basis for short-term forecasts. Rather, it provides a general guidepost about the position of the market within the typical bull/bear cycle.

Overall, it's late in the game.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, relatively favorable market action, and the combination of overbought and overbullish conditions. While the overvalued, overbought, overbullish combination has historically been associated with average market returns below Treasury bill yields, even a decline of a few percent would clear that condition. We do hold a modest position, just under 1% of assets, in index call options to allow for the possibility of a further advance without such a pullback, and I would expect to increase that position toward say, 2% of assets, on pullbacks of even moderate size.

In sum, valuations are rich, and it is unlikely that stocks will deliver satisfactory long-term returns from these levels. Meanwhile, market action is generally good, so there isn't much evidence that investors have much aversion to accepting market risk. So while the long-term danger to this market appears quite high, there isn't strong evidence that would allow a prediction of imminent market losses, beyond enough of a decline to clear the current overbought condition. We can't rule out deep market losses, and recognizing the potential for conditions to change quickly, we would certainly not abandon our defense against them, but my guess is that investors hoping for a near-term market plunge may be more likely to get a sideways trading range for a while, possibly with an upward bias, possibly with a downward one. A measurable deterioration of market internals (breadth, leadership, etc) would substantially increase the near-term risk of deep weakness. We just don't observe that yet.

In any event, our portfolio holdings have started to perform more characteristically, relative to the market, in recent weeks. Meanwhile, we're well hedged against major downside risk in the market, and we have a moderate call option position at extremely low premium cost (as a result of low implied volatilities here) that should allow us a moderate but not excessively speculative degree of participation in a further market advance should it occur.

In bonds, the Market Climate remained characterized by unfavorable valuations and moderately favorable market action. The level of yields and profile of the yield curve doesn't provide a compelling reason to take long-duration investment positions here. The Strategic Total Return Fund continues to carry a short-duration position of just under 2-years, mostly in Treasury Inflation Protected Securities, with just over 20% of assets in precious metals shares, where the Market Climate continues to be quite favorable on our measures.

 

This part seems most notable.

"Though CNBC briefly seemed professional in the wake of the 2000-2002 market plunge, airing short conversational spots where the anchors emphasized journalistic responsibility, that tenor has now been replaced by carnival-barking shows like “Mad Money,” complete with its lightning round, featuring a shrill whine of irresponsible speculative “plays” backed by death-metal guitar music, and “Fast Money” promoted by spots that promise, for example, “Tonight, the boys get down and dirty with a hot commodity...” I wish I was making this up."

 

As noted by someone else elsewhere, the only subject for discussion was whether it was going to be a 'U' or a 'V' shaped recovery and when tech was going to "come back" because that of course was what the public wanted to hear and they tune in to hear what they want to hear.

 

Here is another notable and very scary part of the article. The "4 20-inch monitors" theory. The market is no longer dependent on earnings, analysts, fundamentals, P/Es or anything like that. All it depends upon is a bunch of guys with some monitors who trade the stocks as if they were playing the latest Sony playstation.

The funny part comes when you combine all of this in your mind. You have a bunch of guys totally ignoring whats going in the real world trading stocks on flat screen monitors. Now combine that with some middle-aged fat man screaming stock picks on national television during the "lightning round" to heavy metal music. Then the "fast five" who sing Christmas carols.

There is something truly wrong with this picture. If the fundamentals get ignored and then you have a bunch of clowns like this, where do we go from here?

Maybe all these traders will move over to trade this real soon...

http://secondlife.com/whatis/economy-market.php


"I don't care about the numbers, the economic data, whether Iraq is in a Civil war, if the President gets impeached, who controls congress, what a company does, whether we fall into a recession or if China buys Europe and turns it into a Disney theme park. My world is defined by what I see on my four 20 inch monitors in front of me. Everything else is noise."

 

"Here is another notable and very scary part of the article. The "4 20-inch monitors" theory. The market is no longer dependent on earnings, analysts, fundamentals, P/Es or anything like that. All it depends upon is a bunch of guys with some monitors who trade the stocks as if they were playing the latest Sony playstation."

i think you are misunderstanding

the guy with the 4 20 inch monitors is obviously referring to short term trading. a short term trader (moreso the shorter the timeframe), shouldn't care WHAT the PE of the Dow is. If i am deciding whether to go long or short YM at 3:00 pm, do i care what the PE of the dow is? of COURSE NOT

on the other hand, in my longterm portfolio - you bet your butt i do. and I am much less lightly positioned in equities than i was 1 year ago.

one can be a contrarian with INVESTING (like when I loaded gold in 1998) and still FOLLOW THE TAPE with trading. and clearly, the guy with the 4 monitors is following the tape.

clearly, shorts have been getting slaughtered the last few months

personally, in my B&H and longer term accounts, i am LOVING the weakness in gold as a buy opp, loading some crude, exposing myself to more commodities, etc.

but when im daytrading the dow, im dealing with the tape. valuations are irrelevant.

 

These articles are so ironic. I recall nearly the identical articles in 1998. Not 2000 mind you, by then it was too late. They were the rage in 1998. We're going to crash. These bubbles are imminently going to pop! When we fall, we're going to fall SOOOO hard! Blah blah.

1998. And lots of people kept getting out. Then getting back in. Then out, the sky is falling! We cannot sustain these levels of 'irrational exhuberance'! And those who just sat there long made a disgusting amount of money (I know one person who made 600% in those 2 years alone).

Of course, that money was eventually lost, because the same type of emotional fortitude, unyielding refusal to sell in the face of dips (wisely in 1998), but averaging down instead, came back to smack them in the face in 2000. What worked in 1998 was sheer folly in 2000.

So while I've already read most of the articles you posted yesterday and today, I ignore them.

The ONE and ONLY things I learned from those years is... don't miss the big moves, and insurance is worth the price. I'm not going to miss out on whatever upside there is because of fear.

And wow... the end of 1999... holy smokes profits. We never touched that level of money making this year. A LOT of stocks moved up to $10 A DAY, regularly. My favorite stock back then was Immunex, which every 2 days, I'd make $10/shr. It'd go up like a wound clock. $10 up. $8 down. $10 up. $11 down. 10% every 2 days for months. Unbelievable. No one who remembers trading in 1999 would call this puny moving market amazing.

But the biggest thing I remember was not batting an eyelash at P/E's of 50-100. We have an average 18 PE, we aren't even close to the bubble days yet.

Whether we'll ever get back to those types of bubble days, I don't know. But the warnings, the articles exactly like these, came 2 YEARS before the fall. You can make crazy money in 2 years. All I can say is, those authors sure lost a lot of money sidelined and worrying, through lack of participation in that market.

And by the time they gave up and joined what they could not defeat? They lost all their money. They had no profit buffer like the rest of us rahrahs, only their hard earnings. The rest of us, who were in all the way, lost our profits and a large chunk of our principal (that was still a LOT of money).

The exceptions were the idiots who traded on margin. OMG those were sad. I NEVER EVER go into margin for that reason. I have to have margin accounts to trade... but I only buy with my own money. Margin trading and the inevitable margin calls are the scariest and stupidest thing I witnessed back in 2002.

Will we crash? I don't know. Will we keep going up? I don't know. I do know that the more articles like that I read, the better I feel about the market. You simply cannot have a bubble without a wall of worry the entire time, building like a crescendo.

The more of those articles come out, the more I think... oooh... NASDAQ is 1/2 from it's all time highs. Lots of liquidity. No better investment vehicles right now. Maybe... Maybe... but then I start to worry again.

Then I buy more stocks.