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Our "As You Wish" Markets Have Reached the Cliffs of Insanity

Next stop: the Pit of Despair?
Friday, July 19, 2013, 11:41 AM

In the classic fantasy rom-com The Princess Bride, the beautiful maid Buttercup orders the farm boy Westley to perform numerous tasks to test his servitude. No matter the magnitude of the request, Westley simply answers "As you wish" and makes it so. Buttercup eventually comes to view Wesley with similar devotion, and true love is born.

Similarly, investors have fallen back in love with the capital markets, whose continual response their increasingly irrational hopes has been "As you wish."

Slumping GDP & Revenues

For example, U.S. GDP growth is awful it's slow and getting slower. It grew 1.8% in Q1 (lower than initially thought) and now analysts are tripping over themselves in a rush to lower their target estimates for Q2; some to as low as 0.3% (Morgan Stanley).

Stock prices are based on assumed future earnings growth. If it looks like companies are going to grow their profits faster in the future, then stock prices should go higher. So, in an economy displaying sluggish/decelerating growth, math would dictate that earnings growth estimates should be handicapped by some factor and stock prices should moderate. But that's not happening in today's markets.

Similarly, freshly released Q2 company reports show that a growing number of the largest companies are missing their revenue expectations. And where revenue goes, so earnings (eventually) must follow:

Where Did All the Revenues Go? (Zero Hedge)

According to Deutsche Bank, of the 70 S&P500 companies reporting so far (excluding this morning's GE EPS beat and revenue miss), 50 have beaten EPS estimates and only 20 of them have missed. As for sales revenue, just 37 of them have topped analysts' estimates and 33 of them have missed. In reality the revenue beat % is also being skewed slightly higher by the stronger top line performance in US financials so far. If we strip aside US financials, the revenue beat:miss ratio is around 45%:55%. Coca-Cola, Yahoo, Intel, IBM, eBay, Google, GE and MSFT are just some of the household names that have disappointed on the revenue front so far. 

One thing is certain: based on the one metric companies can't fudge, the global economy is not only slowing down, but what's worse, the hundreds of billions of incremental money created by central banks one and all, is not even making its way into the corporate revenue pipeline. For now, the "hope" strategy has worked (i.e., next quarter things will be better). But this final fallback, which so far has only disappointed, will soon no longer work, when virtually every known accounting tactic is used up and there is nowhere else to go for EPS than where revenues have already been heading for the past two quarters. Down.

With the downward trajectory in corporate revenues, forward earnings expectations should be moderated from their prior levels and stock prices should adjust downward. But, again, that's not happening in today's markets.

Instead, like Buttercup, Wall Street is petulantly demanding rising prices, and the markets are answering: "As you wish." Yesterday, July 18th, both the Dow and S&P 500 closed at all-time highs.

Indeed, the markets have been busy the entire past year making wishes for high prices so. And the pace at which these higher prices are being delivered has increased in the past month:

(source: Finviz)

The chart above shows that in July, the slope of price appreciation has become nearly vertical completely ignoring the slowing GDP and revenue data. To borrow from The Princess Bride again, we've reached the Cliffs of Insanity:

Rising Oil Prices

But there's more that's making rising stock prices seem even more irrational at this time.

Oil, the master resource that greases the gears of the global economy, has been rising, too.

Today, oil briefly rose above $109 a barrel. It has risen over $15/barrel since early May.

When oil prices rise, the cost of conducting business rises. Therefore, corporate earnings decline. In addition, the price of gasoline rises, hurting consumer spending, which compounds the decline in corporate earnings. And the expectation of these lower earnings should lead to lower stock prices.

But as we see here, the S&P has powered higher during the upward march of crude prices:

Rising Interest Rates

To make matters even worse, interest rates have recently started rising. This will be a huge development if it continues, but rates are already 60% higher than they were a year ago and are sure to have a cooling effect on economic activity (as borrowing costs increase, resulting in less purchasing at both the wholesale and retail levels). Perhaps they already are, as reflected in the slowing GDP numbers above.

Inconceivable!

Just as The Princess Bride was a great fantasy, so is any convoluted rationale being used to justify the current elevation of prices in today's capital markets.

What if we were to teleport in time to the beginning of the year and ask any impartial analyst what would happen to stocks if H1 2013 experienced:

  • A dramatic deceleration in GDP
  • Revenue misses at many of the biggest blue chip multinational companies
  • Sharply rising oil prices
  • A long-term trend reversal towards rising interest rates

The call would have been easy and likely unanimous: Stocks will go down. Or at the very least, enter a defensive "wait and see" trading range.

Of course, that's not what's happened. And the point here is not to bemoan the past, but to ask: What's more likely to happen from here? A continuation of the same extreme outlying behavior? Or a return to relationships that have governed markets for centuries?

To help in your decision-making, Bank of America just reported that money is now entering the U.S. stock market at the fastest rate since June 2008 (right before the last big market crash):

Largest weekly inflow to U.S. equity funds since June ‘08 (note market value of S&P500 index, adjusted for float, exceeded $15 trillion for the first time ever today) Huge $20bn global equity inflows versus $1bn out of bonds.

That's a classic signal that a market top is near. Money entering (or remaining in) today's stock market with the blithe hope that the party will continue onwards may soon find themselves in the Pit of Despair:

At least the gold bugs will be happy to have the company.

Because to expect continued record stock prices in the face of the very fundamental headwinds discussed here is simply...

~ Adam Taggart

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23 Comments

AKGrannyWGrit's picture
AKGrannyWGrit
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Cliffs of Insanity

Nicely done Adam, love the humor!

Ak Granny

George44's picture
George44
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Cliffs of Insanity

Nice article.  That funds flow graph speaks volumes.

I have to admit that I'm beginning to feel a bit like Linus waiting for the Great Pumpkin to arrive, but I also realize these markets are being driven higher not by fundamentals but rather by QE induced speculation, greed, and, as Adam says, "irrational hopes", as well as the many investors who are simply trying any way that they can to build a retirement nestegg that they'll actually be able to retire on.  It saddens me to think that they are the ones who will suffer the most when markets do reverse course.  Nothing goes up forever.

Arthur Robey's picture
Arthur Robey
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An Unrecognisable Economy.

I wonder which economics genius decided that if you deprive the population of discretionary income the velocity of money would go up?

No matter- without oil there is no recognisable economy. My good friend Barry said that the recent discovery of oil in South Australia was bigger than Saudi Arabia's. Struggling to compose a polite reply I said that it all depends on the price of the oil being high enough. Changing the subject, I asked Barry if he was still looking for gold. He said yes.

Will gold have any value in an unrecognisable economy, or would one be better invested in goats, camels, women and horses? They are all good tradeable assets.

yogiismyhero's picture
yogiismyhero
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Yeah Adam...

...you did good.

Nate's picture
Nate
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humor
Arthur Robey wrote:

Will gold have any value in an unrecognisable economy, or would one be better invested in goats, camels, women and horses? They are all good tradeable assets.

Arthur,

How many goats does it take to get a women?

Arthur Robey's picture
Arthur Robey
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A Womans Worth.

Historically a woman goes for between 20 to 50 cattle, and a cow is worth about 10 goats therefore a woman is worth between 200 and 500 goats, depending on the quality. A young strong one with good child bearing hips is at the upper end.

They come with guarantees. If she does not fall pregnant you can ask for your goats back, but only after your brother also fails to impregnate her. This is fair because you might be the infertile one.

A Scotsman wanted me t marry his daughter and was willing to throw in two cows, but that is another story.

See Lobola.

SingleSpeak's picture
SingleSpeak
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Posts: 496
Alarms were triggered at the NSA

by the last couple of posts.

You guys are going to get us shut down if you're not more careful.wink

SS

Arthur Robey's picture
Arthur Robey
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Alternative Realities.

Just stating the bald reality of an unrecognisable economy, SS. You can check it's veracity by going to the wiki link that I provided. I flew over Lesotho and realized that they were not going to be affected much by our predicament.

I see that Max and I are in agreement. There is no such thing as wage inflation anymore, only asset inflation. Meaning the Hot Money is going into commodities. (I am not a fan of his style, but respect his content).  There was mention of Oil inflation, which is driven by the hot money.

Max Keyser.

jgritter's picture
jgritter
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Dang dawg!

Wow, Arthur, way to kick over a hornets nest!  I will be fasinated to see how this thread falls out.  A line for "women" under under "Today's Markets", however, would lend valuable information as to the true state of the economy.  To my sisters out there, please take a deep breath before jumping in.

John

Rob P's picture
Rob P
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Posts: 85
Yes, right - as always

Adam, you know, it appears to me (no expert really) to be a really sound assessment of the situation as it is now taking shape. Thanks for pulling that together.

It looks like margins are getting squeezed and that this will probably continue. In any rational universe falling earnings would result in a crash or at least a pull back in equities. 

Here's, another, similar assessment from this morning:

http://www.marketwatch.com/story/critical-warning-no-17-dow-5000-crash-o...

It is clear that the micro and macro factors that would lead to a general equity drop are increasing. 

But, honest to God, I've been watching all of this for a long while now and I'm just amazed, amazed, amazed, amazed at how long the irrational can hold up in the face of facts and reason.  I suppose that when reality does appear it will be quite a jolt, but, I'm not betting on when that might be. 

The stock market is somewhat self perpetuating.  It goes up - look everbody, proof that it goes up - jump in - rinse and repeat. Just for the record I am totally out of equities at this time - except that I'm buying solid gold miners for the long haul as they are a true value at this point.  Not to say they couldn't go down further; they definitely could, but its a calculated risk based on value, for the long term on a well thought out percentage of the investments.  But, save that,  I'm out of equities as in zero - but let me tell you this state has me very concerned - negative real return.

On the one hand there are people, you and CM, CHS, Mish and a boatload (small rowboat) of others who have been making rational arguments of all sorts for years now.  But then you have a whole lot of other people (I guess it's the entertainment on the Titanic), mostly technical analysts who perpetualy present various arguments that everything is set for up up up in equities - and then they actually keep doing just that (save the latest recent little pullback - now erased). I have thought  these people to be a gaggle of delusional idiots or fed sycophants or something like that for years now (and they are), but  the S and P just keeps going up anyway.

But I will tell you from personal experience - from right here on the ground.  There is huge pressure to get a return on investment from somewhere to at least, at least, keep up with the REAL inflation rate and preserve wealth.  It would seem to follow that falling earnings - not just earnings but dividends - will function as a signficant disincentive for equites. And also, that rising interest rates will attract lots of savers (well "lots" - the 2 or 3 Americans who actually have significant savings) in order to get a return at reduced risk.  I don't know how significant this actually is; small savers clearly don't run the markets, but this is accurate description of what some people face.

But I would say that right now, based on as much as my non-expert, but still attempting-to-be rational mind can discern, things look very potenetially deflationary in the short to medium term. OK, you say looks like the equity markets will drop (I agree "looks like").  Icarus' wings are definitely getting a little soft around the edges - but again it's been that way for a long time.   My next question is: in such a case what would be the Fed response and the government response (congress). 

Also, you must (attempt to) figure into any investment predictions and decisions:  China,    the middle east,   and especially, Europe.

Anyway, that was a very good analysis of a major peice of the current puzzle as it appears to be taking shape.  I really appreciate your work.

 

Arthur Robey's picture
Arthur Robey
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Values versus Observations.

I was puzzled by your response John, and then it occured to me, you were confusing my observations with my values.

I had better be crystal clear in this issue. I love my western civilization and its fruits. I offered up another mode of existence as a counterpoint to ours, and as a warning of what will befall us if we do not find another source of portable energy.

And now back to Adam's thread.

BeingThere's picture
BeingThere
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Decoupling Main St. and Wall St

This is the result of handing total power to the very perpetrators of world financial collapse to undo the damage in the first place.

There were no strings attactched and no accountability, but to re-build the stock market and all it implies for 401k's IRAs and pensions. The problem here is that the logic was so weak, as to amaze the populus all the while claiming that all bonuses were to be born out to those of great talent. A promise is a promise they claim, as they brought in their cronies to get in on the act. The financially illiterate will pay.....We're  talling tens of $trillions.....

This idea is a never-ending loop as they will assuredly cause a great crash again and all the other countries? Will they keep working with us as their populations start to suffer more than now? Is there a tipping point where Icarus comes crashing to the ground?

Bill Black explained what the options were for lawmakers during the Reagan administration when the government was still functoinal, but what we have is a criminal enerprise, formally known as the USA and they spread the joy militariy and financially around the world.

They have effectivly decoupled Main Street, which is being starved (see Detroit) from Wall Street which is creating wealth from thin air and stashing it away in black banks.

Yes, we see a play for rampant privitization Milton Friedman style. The no regulations bunch who pay off municipalities as they destroy them, is in full force. See Gasland 2 on HBO if you want to see how they take over land--even private land  for fracting. As some distressed homeowners say, there's no such thing as private property.

I live in NYC and was talking with a store owner in his late 60's who has suffered a tremondous drop off of buisness and says his IRAs have not grown in years. What are the masters of the universe going to do with millions of people who they have made insolvent?

 

 

BeingThere's picture
BeingThere
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The modern experiment is over

Yes, they are sending us all back to the future. After lying about the US as the great Saui Arabia of nat gas, there will be a reckoning I'm afraid---and lots of disruption.

Our future is in  the hunter gatherer and farming mode, I guess if the aquifers and land aren't utterly destroyed by fracking.

herewego's picture
herewego
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More Humor

If the future price in goats of women with good hips makes you giggle, then the value of a strong male slave in sheep ought to double you right over.

Just saying'. We'd be better in this together.

Susan

robie robinson's picture
robie robinson
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sheep? men?

"One man is worth two sheep(I'm both a male and a sheperd) two men are worth one sheep, and three men ain't worth no sheep at all."

 

robie

yogiismyhero's picture
yogiismyhero
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I counted all my goats and slept like a baby...

...Just more Adam to add to your essay, and again, you did good.

http://www.zerohedge.com/news/2013-07-20/guest-post-2007-redux

davefairtex's picture
davefairtex
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hussman agrees with Adam

John Hussman tries to validate his market approaches by conducting backtesting against a collection of historical full market cycles.  He makes the point in this article that "buy and hold" does perform well, but tends to be most popular as a strategy at market peaks, and then becomes very unpopular at market bottoms.  The net effect of this is to show that people have a very hard time holding their equities through 40% declines, which regularly appear during the course of a full market cycle.  I'll let him continue:

http://www.hussmanfunds.com/wmc/wmc130722.htm

Presently, we observe a syndrome of strenuously overvalued, overbought, overbullish conditions that have marked the most notable market peaks (and deepest subsequent market losses) in history, including 1929, 1972, 1987, 2000, and 2007. With the exception of a particularly extreme version of this syndrome that will be recapitulated next week as long as advisory bullishness remains at its present level, every important variant of this syndrome already collects the present instance into a small subset of history that we call a “Who’s Who” of awful times to invest (see the July 16, 2007 weekly comment A Who’s Who of Awful Times to Invest for a review of similar concerns approaching the 2007 peak, and Puppet Show and A Reluctant Bear’s Guide to the Universe for other discussion).

However, the process of a market top often takes time.  He explains here, and supplies a nice chart (see the article for details) that demonstrates his point:

Meanwhile, it’s important to distinguish between the severity of conditions and the immediacy of outcomes. A notable feature of many bull market peaks (outside of “V-type” peaks like 1987) is an extended period of churning over several months or even quarters. For example, the 2000 and 2007 peaks were followed by two of the worst market declines on record, yet the apparent resilience of the market following interim corrections around those tops produced a sense of security and complacency despite what would prove to be profound downside risks. In short, the fact that we observe severe conditions at present doesn’t necessarily imply an immediacy of negative outcomes. The interim sense of security may be illusory, but it certainly contributes to frustration and impatience if investors don’t recognize this pattern.

[Bold added by me]

yogiismyhero's picture
yogiismyhero
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What makes Adam's essay so relevant is that...

...we see it all, have experienced the fall out as recently as 2008 and no improvements from all the printing. Just now we will see what the unintended consequence of all this thin air cash will produce. My guess, " she's gonna blow captain, she's gonna blow, I've given her all I got and nothing". As Charles once said, "like pushing on a firecracker". Kaboom!!!

yogiismyhero's picture
yogiismyhero
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Posts: 173
Hussman, so glad Dave referenced his material...

"The easiest way to lose discipline is to measure each day by whether it was up or down. At the end of the day, the only controllable measure of success is the extent to which you’ve taken a studied, well-defined set of actions that you are convinced will produce good results if you follow them consistently. For us, that habit remains as strong as it was in the face of similarly frustrating, mature, overvalued, overbought, overbullish conditions in 2000 and 2007."

http://www.hussmanfunds.com/wmc/wmc130722.htm

He is just one of many who does indeed make what Adam said here fundamentally worth researching and keeping a keen eye towards.

 

CantoL's picture
CantoL
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Posts: 6
Oscillations Don't Lie

Markets go up, markets go down, but markets ALWAYS have a long-term median value which remains relatively constant over the decades. If a market is significantly above or below that median, you can be sure that a correction will occur.

Today, the Shiller PE stands at 24.74. The long-term Shiller PE median is 15.88. We're 50% overvalued. Just as telling, since 1990, financial markets have hovered above their historical median 90% of the time, with only one massive correction (2008) briefly taking us below the median.

http://www.multpl.com/shiller-pe/

It seems that our financial markets have been successfully disconnected from value-reality since the later 1980s. This means that our financial markets are decreasingly reflecting collective values, while increasingly reflecting special interests. This correlates with the profound drop of middle-class wealth beginning in the 1970-1980s.

I don't blame Wall Street. I blame you, me, and everyone reading this comment for allowing our political system to become an overt Wall Street proxy, a revolving door of special interst lobbying. If WE don't fix the mechanics of political-corporate incest, these cycles of financial excess will only worsen.

GrandSupercycle's picture
GrandSupercycle
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Posts: 14
How To Cause A Crash.

The Bernanke Put & USD suppression has dangerously distorted markets which will result in a massive Wile E Coyote collapse.

FED policy will cause a MASSIVE CRASH.

Guaranteed.

http://trader618.com/2013/05/22/how-to-guarantee-a-crash

http://trader618.com/2013/06/21/fri-21-june

http://www.peakprosperity.com/forum/81162/market-analysis

yogiismyhero's picture
yogiismyhero
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Posts: 173
I loved this story as the Banks were the ones who...

...created this silly game we are playing today, have no morailty and only greed and again why they have "killed the goose who lays the golden eggs" are beyond me. A tit for tat story that has me beaming with joy. Enjoy http://www.zerohedge.com/node/477013

It's the kind of story that if it catches on will flood the market with all the hidden and bank held properties and drive down the costs of these homes as it should, and make them truly affordable to those wage earnings who haven't seen an increase after inflation in their take home pay. The Banks, they take the hit and all is well with the world. OH!, the webs we weave when we look to deceive.

 

yogiismyhero's picture
yogiismyhero
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Posts: 173

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