Sunday, January 17, 2010

The Stock Market: Priced, Again, for Perfection

Last week, both Intel and J.P. Morgan announced earnings that significantly beat Street estimates. The market promptly dropped. What gives?

Analysts questioned the loan losses at J.P. Morgan; revenues were also below expectations. Intel's results generally drew praise. The problem, it would seem, is that the improvements at both companies didn't surpass expectations enough. In other words, hitting a home run isn't good enough these days. To see your stock price rise, you have to hit a grand slam home run out of the park, beyond the parking lot and across the street. One doesn't have to delve into the world of whisper numbers and other market rumors to understand what's going on. Just look at the price-earnings ratio.

The price-earnings ratio for the S&P 500, based on trailing earnings, is 70.79 (see p. B4, The Wall Street Journal, Jan. 16-17, 2010). This is way, way, way higher than the historical average of 15. A p/e ratio this high means that investors expect tremendous improvement in earnings or that we have a deliriously bubbly market. Or both. (See Whatever the case, it's clear that the market is priced for perfection. Anything less than absolutely gorgeous, gem quality financial reports from bellwether stocks like Intel and J.P. Morgan, and the market will start getting butterflies in its tummy. If this seems familiar, think back to the market peak in 2007, when the Dow topped 14,000, or the tech stock peak in early 2000.

After rising 60% in six months, the market has risen only 4% or so in the last three months. The bull is tired after its long run. Most analysts predict high quality earnings reports this month. But will that be enough? A p/e ratio of 70.79 sets the bar at stratospheric levels.

Some gamblers think that if Scott Brown, the Republican candidate in the Massachusetts special election for senator (to replace the late Ted Kennedy) wins, the market will take off in the belief that a Republican victory will kill health insurance reform and constrain federal spending. If you want to bet on this play, make sure you have your stop loss orders in place. The Democrats can work their way around the loss of a 60-vote majority in the Senate by having the House approve the Senate version of the reform bill or by rushing a compromise bill through the Senate before Brown can be sworn in. Neither alternative would be easy, but both are more palatable to the Democratic leadership than a failure of health insurance reform. The Democrats misjudged the voter sentiment in Massachusetts. But their problems with control of the Senate and the threat it poses to health insurance reform now have their full attention. Be cautious about betting your money on the Democrats making more mistakes.

You might want to get stop loss orders in place anyway. Even if Martha Coakley, the Democratic candidate for senator in the Massachusetts special election, wins, the late Republican surge sends a loud and clear signal to the Obama administration to hold the line on deficit spending, something the administration cannot ignore with the fall mid-term elections approaching. Whether or not the economy needs more stimulus, it won't be getting much more, if any, from the federal budget.

Of course, there's always the monetary printing press at the Federal Reserve, which recently installed showers and bunkrooms for the employees working 'round the clock. But even the Fed, which in the last 15 years hasn't met an asset bubble or an inflationary threat it didn't like, will eventually realize it's pushing on a string. The banks the Fed has been subsidizing are sitting on top of their very cheap federal funds instead of lending them out, while maintaining myriad unbooked losses (with the help of a politically coerced relaxation of accounting standards last year), reporting the resulting "earnings" (it's amazing how well a bank will do if loan losses are unbooked instead of booked), and paying really big employee bonuses. The Fed has avoided triggering inflation because the banks have avoided lending out their federal assistance. They hoard it against the need to book more loan losses. Since the funds don't circulate, they don't trigger inflation, but they also don't stimulate economic activity. That doesn't bode well for a stock market priced for perfection. Caveat emptor.

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