What's Driving the Stock Market? Hint: It's Not Earnings

John Mauldin |

The consensus I’m hearing and reading from the 500+ attendees at the recent Strategic Investment Conference is that this was the best ever. It was certainly intense, with more divergent views presented this year than at previous conferences. Plus, the range of topics was rather dramatic. This year I was able to listen to all but one of the presentations, and I want to share with you my notes and takeaway thoughts. (In addition to my own notes as a source for this letter, my associate Pat Watson sent me his notes, as well as links to a summary by attendees Chris Bailey and my good friend Steve Blumenthal. I borrow freely.)

I put a great deal of effort into planning the speaking lineup for my conference. It is routinely called the best macroeconomic investing conference in the country each year, and I have to humbly agree. It takes work to make it that way. Last fall, when I began to consider my lineup for this year’s conference, one of the big questions on my mind and the minds of nearly everyone I was speaking to was Federal Reserve policy, so I specifically looked for a few new speakers who could address that concern. The topic of what the Fed would do and what the effects would be was a running theme throughout the conference. That concern is mirrored in the following quote from Stan Druckenmiller. (I think I’ll try to get him to come to the conference next year.)

Earnings don’t move the overall market; it’s the Federal Reserve board. And whatever you do, focus on the central banks and focus on the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.

Note: In a departure from tradition, cosponsor Altegris Investments has agreed to allow me to share one video of a conference speaker per week for the next few months. The videos are in production, and I hope to be able to bring you the first one next week. Now let’s look at my notes.

SIC 2015: Speaker Notes

First up was David Rosenberg. Rosie has been my leadoff hitter for a number of years and is a crowd favorite. Never in all these years has he failed to bring a new presentation. My associate Tony Sagami, along with a number of other attendees, thought that Rosie’s presentation was the best of the conference. It was certainly one of the most bullish. David was consigned to the permabear camp for many years, but he actually turned bullish at my conference about four years ago, which was pretty good timing.

He called the current economic expansion “The Rodney Dangerfield Expansion,” since it gets no respect. The economy is tepid, in large part due to the shrinkage of the working-age population. Baby Boomers didn’t have enough sex, and Millennials are delaying parenthood. There are not enough people to buy houses and consumer goods. (Pat Watson quipped: “I think the Boomer generation had plenty of sex. The problem is it was the non-procreative kind. FDA approved “the pill” in 1960, and birth rates plummeted soon afterward.”)

Nonetheless, at 70 months so far, the weakest post-World War II recovery is still the sixth-longest expansion since the Civil War and deserves more respect.

Rosie contends that interest rate hikes won’t necessarily hurt stocks. The last time the Fed hiked was June 2006, and it took 18 more months before the market started to crack. He offered this slide:

He predicts the Fed rate hike will not bring an end to the economic expansion or bull market. It is when the Fed tightens too much that they invert the yield curve and recessions start. All the “bad stuff” happens after the last Fed rate hike in a cycle. This expansion will end, too, but may not be over until 2018, Rosie says. On the profits recession: if you strip energy out of the S&P 500, profits are actually up. Energy earnings are down 64%. Central banks are gobbling up the Treasury supply. Note the drop in marketable Treasury securities outstanding from $2 trillion to $700 billion.

S&P 500 earnings ex-energy look fine. Therefore stocks are not as expensive as you think. Real bond yields are negative; bonds are overvalued. (Bonds being overvalued was a theme sounded by multiple speakers at the conference.)

Inflation is running close to 2.5%. There is more inflation beneath the surface than meets the eye. Real yields are negative. Institutions have to buy T-bonds. You don’t – risk-reward is not in your favor. Bonds today are strictly for speculators. Coupons no longer provide any downside protection. Rosenberg offers his strong conviction: equities will be the best-returning asset class; stocks will outperform bonds.

Credit Sucks

Next up was Peter Briger of Fortress Investment Group, one of the largest private credit funds in the world. He had one of the better lines of the conference, which I just have to note. (Remember, he’s been embedded in the credit world for decades.) “Credit sucks,” he quipped. He’s not interested in any long credit assets. He said this about 20 times in different ways. You get the idea that he really hates credit now.

“Don’t buy anything with a CUSIP.” There are opportunities, but they aren’t easily available to the public. The credit assets you can actually trade do not have a sufficient liquidity premium to justify their risk. We will have great opportunities in a high-default environment when the financial system is on its ass. It’s coming but not here yet. He would love to short German bunds, but trading mechanics make that very hard.

His remarks struck me as being part and parcel of a theme that has begun to show up a great deal recently in conversations and in my reading: there is an accelerating dropoff in the liquidity of fixed-income markets. There are several explanations for this, not the least of which is that the new regulations that resulted from Dodd-Frank have forced banks to pull back from providing liquidity and taking risks with capital. Bond funds promise daily liquidity; but in an exit, when herd mentality kicks in, there will simply be no liquidity for those funds; and pricing will go out the window. I was having lunch with an investment advisor today (who was at the conference), and a theme of our conversation was that bonds have to be considered risky. He is actually reducing exposure to bonds in his conservative portfolios.

Which brings us to the presentation of Dr. Lacy Hunt. Lacy is still recommending to his clients that they be invested in long-dated zero-coupon bonds, which his funds over at Hoisington Asset Management utilize. Lacy (along with Gary Shilling, who followed up with Lucy in the Q&A session) has been recommending long bond positions for 30 years. He does not feel the bond bull market is over. I want to cover some of the ideas he presented and then talk about how both Lacy and Rosie can be right.

Characteristics of Over-Indebted Economies

Lacy is clearly in the deflation camp. Let’s see if I can summarize his conclusions about over-indebted economies:

  1. Temporary economic growth spurts can’t be sustained.
  2. Weak demand caused by payment obligations creates structural downturns.
  3. Productivity falls without inflation.
  4. Monetary policy is ineffective.
  5. Inflation falls dramatically.
  6. T-bonds fall to extremely low levels.

Nominal GDP is the best indicator to judge over-indebtedness. Per capita GDP shows standard of living growth averaged 1.9% from 1790–1990 but only 1.0% from 2000–2014. The real indicator and culprit for the weakness is public plus private debt as a percentage of GDP. Currency devaluations don’t help, because they simply steal growth from others, who then retaliate.

Tendencies of over-indebted economies:

  1. High debt tends to be a global phenomenon.
  2. Rolling currency devaluations get thwarted by the Nash equilibrium.
  3. Currency changes deliver no net gain, only a transitory benefit.
  4. Currency devaluations reinforce global disinflationary conditions.
  5. The only cure is a significant multi-year savings boom OR austerity.

Austerity is either self-imposed, forced by external demands, or naturally evolves through fortuitous circumstances.

Secular Versus Cyclical

Next week I’m going to be conducting a little “debate” with our new associate at Mauldin Economics, Jawad Mian, who is expecting a return of inflation, which doesn’t exactly sound like one of my themes. He’s going to present his case, and then I will present mine. A few of our mutual readers have wondered how we can have such different views. The answer is actually in our time frames. I’m not really a trader as such and tend to look out over a longer horizon. Jawad comes from a hedge fund background and is quite focused on the current period. (You can see Jawad’s latest letter here – we have made it available for free.)

Lacy has a secular view of interest-rate dynamics, while many of the other conference speakers (but not all) were far more interested in what is going to happen over the next few months and quarters. It is important to understand the time frame of the speakers as well as to understand your own time frame and personality. If you have a long-term investment plan but a short-term mentality, you are not going to be able to stick to your plan. Let me say that there is absolutely nothing wrong with having a shorter-term view of the world if you have a plan that works in that perspective. Trading is a lot harder than it looks, like some of those crazy stunts that are done on TV right after the host looks into the camera and warns the viewing audience, “Don’t try this at home, boys and girls.” Then again, it can be tough to sit through cyclical ups and downs when they are going against you.

Everything That’s Obvious Is Wrong

Lacy was followed by one of my favorite economic commentators, Jim Bianco. His speech consisted of four themes, which I will summarize:

“Everything that’s obvious is wrong.” The earnings game is rigged by Wall Street: companies almost always beat expectations because they keep changing the expectations to match their realities. Jim is worried about the stock market but not afraid of a crash, as in, he doesn’t think one is likely. QE is the problem, not the solution. The Fed thinks it has a third mandate for “market stability.” Therefore it spends all its time trying to make sure Wall Street doesn’t get upset. He had an interesting chart showing that crude oil prices and world growth expectations track closely.

Paul McCulley was up next. He was perhaps the most unrepentant Keynesian to present at the conference, where he has been a mainstay for 11 straight years. This is the first time in a very long time that he had absolutely no facial hair. He was almost hard to recognize. He summarized some of his previous correct predictions. Most notably, 2008 was a Minsky Moment (I believe he coined the term), which is a liquidity trap – a period when the private sector has too much debt, which fuels a bubble. The dot-com bubble wasn’t debt-financed, so it popped quickly and was over. The housing bubble was worse because it was debt-based as well as based in illiquid assets.

When a debt-fueled bubble collapses, you get a recession. Monetary policy is ineffective in such recessions. Debt is too large relative to asset value. Private-sector debt generally creates tax revenue, making it easier to justify government stimulus (there we disagree). Fiscal stimulus is the right answer. Austerity is the wrong answer.

Louis-Vincent Gave flew in from Hong Kong to present his rather bullish view, not of the US stock market but of China.

“Money managers are paid to adapt, not to forecast,” he told us. Peak oil was hogwash, so why did it take so long for the oil price to collapse? The oil boom had all the elements of a traditional bubble. Now it has burst. Why? His answer is China. There is a new, ruthless ruler, Xi Jinping. Xi’s deal with Putin shifted the dynamic, putting China in the driver’s seat. The China-driven commodity bubble was a “good” one since capital markets financed it, but it still led to the present deflationary shock. Asia was the biggest commodity consumer, so now it is the biggest beneficiary of lower prices.

Louis believes there is a huge change coming, with China pressuring the IMF to add the renminbi to the basket of four currencies (USD, euro, UK pound sterling, and Japanese yen) that make up the special drawing rights. He thinks they will probably get their wish at the November 2015 IMF meeting. This will let other central banks hold RMB, which they will do because it has a much higher yield than the alternative currencies (the four listed above). The result would be the lifting of Chinese capital controls and a sharp increase in China’s weighting in world equity indices, forcing everyone to buy. The current China rally is front-running the entire world.

Louis is also bullish on Europe. Everything is lining up well, he says. He thinks the reflation plan will work. He does say to underweight the US. Valuations in the States are too high; P/E expansion can’t continue. More than one third of S&P 500 earnings come from abroad, and dollar strength is killing them.

His broad conclusions? We are still in a deflationary period. The emerging market/developed world dichotomy no longer matters. Asia is in a broad bull market that will continue. Europe is in the sweet spot – a must-seize opportunity.

He did point out some potential risk factors: Russia, Eurozone upheaval, and a US bear market.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click hereImportant Disclosures

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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