PARTS OF THIS MARKET ARE LOOKING IRRATIONAL
I haven’t thought the 75%+ rally was particularly irrational over the course of the last 12 months. Surprised by the strength? Absolutely. But irrational, no. As of late, we’ve begun to see signs that the consumer is back, but the equity action implies that the consumer is not only back, but ready to break records. In late 2006 I wrote a letter that said:
“So here we sit with a relatively healthy economy, signs of inflation and record housing prices. Sounds pretty good, right? Not so fast. The markets could certainly move higher if housing doesn’t collapse, but we see very few scenarios in which that can happen. When the housing market slows consumers will spend less and businesses will begin to suffer. The US economy will then fall into a recession and European and Asian countries will quickly follow suit as the world’s greatest consumers wilt under the environment of low liquidity and higher debt….The credit driven housing bubble remains the greatest risk to the equity markets at this time.”
I said the market was due for a potentially crippling recession as the yield curve inverted, consumer balance sheets were turned upside down, and a housing bubble was brewing. Just days before the market crashed in 2008 I said the market had all the ingredients for a crash. In late 2008 I said the market had overreacted and would likely revert towards the mean in 2009 for a total return of 18%.
The day before the market bottom in March 2009 I said government intervention would likely generate an equity rally. But I did not come close to predicting that we were on the precipice of a 75% 12 month move. Not even close. On the other hand, I have never thought the move was particularly irrational and didn’t fight the tape through 2009.
I was very constructive on the market heading into 2010 and maintained that stimulus, strong earnings and an accommodative Fed would result in higher stock prices in H1. I point this out not because I am trying to toot my own horn or gloss over my many imperfections (many can be emphasized), but overall I have been able to not only foresee the macro mechanics driving the market, but have also done a fine job translating that into price action.
But where do we sit now? We are beginning to see some glaring disconnects between the market and reality. There are very real improvements versus where we were just one year ago. The recovery is here and it has been stronger than I expected. But there are also signs of irrationality on the fray. This is nowhere more apparent than it is in the consumer sector. The retail holders index is one of the few indices that has experienced a full-blown v-shaped recovery. Just how wide is the disconnect between the consumer and retail stocks. Let’s compare and contrast 2007 and 2010:
We have lost 7.8 million jobs since then. The unemployment rate is 9.7% versus 4.5%. Total unemployed workers are now 15.7 million versus 6.5 million. Real personal income less government transfers is lower by 6.5%, or $624 billion. Real retail sales have rebounded just 4% from their lows and are still down 9% from the 2007 peak. Consumer credit for February showed another sharp retrenchment of -5.6B. Consumer bankruptcies for March were the highest level since 2005. There is a glaring $1.5 TRILLION hole in the consumer balance sheet. Home foreclosures surged 19% last month and are at their highest level since 2005. The consumer’s largest asset (housing) is down 33% since 2007.
Meanwhile, the retail holders index (RTH) is back at its pre-recession highs. Granted, the market is a discounting mechanism and this index has benefited greatly from retail expansion and improved corporate efficiency, but operating income at the index’s top 25 holdings is down 4.5% from 2007 and that’s including new stores! This doesn’t rhyme with a near all-time high in the retail index. This price action is acting as if the consumer is (or will become) whole again – which I believe is undeniably false. Is the consumer on the mend and willing to spend again? Most certainly. Whether this is a good thing is a whole different debate, but as of now there are still few signs that the consumer is back to full strength or even close despite the market acting as though Goldilocks is here and ready to party.
Of course, I’m talking my book as I sit on my first sizable short position in over two years (which has been a terrible call thus far), but the evidence appears clear to me. This market is pricing in more than a Goldilocks recovery. It is pricing in sheer euphoria and the data just doesn’t rhyme with such an environment.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
Follow Me:
29 Comments
You got brass ones to be short now TPC.
TPC, what is your reaction to the tepid market reaction of the Google results? Revenues were still up and away, but it seems like, for the first time in a long time, the market actually paid attention to the bottom line. Is this a sign of things to come? Is the analyst community adjusting to the new economic outlook? Are people simply selling the news? TIA, always love the material, please keep up the good work!
We’re going higher. Goldman gets what Goldman wants.
You spoke too soon.
That said GS will get light slap on the wrist with JOKE fine.
TPC the people above me and their comments should make you feel good about where you are short right now
I am short U.S. Steel, not an actual index. I was in TZA but sold it around 7.20 (after buying at 8.26) when I saw the R2K break through the trend line which is bullish and was. Now TZA is trading at 5.80 something. Good luck TPC.
Well, perhaps it is because of people simply shifting from Europe to US and bonds to stocks? Also, wonder if RTH companies are expanding in emerging markets/other non-US markets and people like the growth potential there? Also, interest rates are lower than in 2007. I’m just making a lame attempt to rationalize.
It can take a while for the short thesis to play out – when it plays out it will be quick. Maybe, you will make money soon on the short side.. March-May is usually a tough time to be short (as in 2008).
Emerging markets have been underperforming the US throughout this year though – so atleast the markets are differentiating somewhat between risk assets – what it all means will be interesting to watch.
Isn’t the devil in the details, though? The top ten holdings are all retailers that sell lower priced goods or discount. Might one expect this type of retailer to gain market share in a tougher economic climate?
GE & BAC blowout earnings. Shocker.
good post tpc.
i can’t figure out the particular strength in consumer discretionary and retail, especially given state of consumer. i just underweight those areas, however, i don’t short them.
this thing going on is plenty powerful.
interesting graph from bespoke: http://www.bespokeinvest.com/thinkbig/2010/4/15/two-months-of-up-days.html
two things of note: first, when the market previously hit over 30 up days over a two month period (as we have just experienced), there was a great deal of volatility; second, i was surprised how almost the entire period was above the 20-22 up day level (i assuming that 20-22 days is a proxy for 50% up days). this tells me that if you can avoid the bad times (as opposed to just buy and hold), you will supercharge your results.
Interesting topic – I just sent my friend an email discussing the strength in retail and retail stocks. Here is the email and sorry for the length:
“Retail sales were up 1.6% in March from the previous month and up 7.6% from a year ago. I took a look at the total times series from the Commerce department, which dates back to January 1992. Amazingly, except for a few one-month hiccups (such as 9/11) and some small seasonality, retail sales rose every month from January 1992-June 2008. The wheel of the consumer finally came off and retail sales fell through December 2008. Since then, retail sales have been volatile but the trend has been up, including the latest month.
This tells me a couple of things. One – retail sales are probably highly correlated with population growth. We should maybe start looking at sales per person for a better picture of retail sales. Otherwise, the incentive is to just grow the population and consumer, two things that will eventually implode the world. Two – the consumer literally got scared for 6 months out of the last 219 months of retail sales. 6 months of consumer fear (along with all the other madness in the markets) helped bring down this market, which is pretty scary if you think about it. 6 months is all that consumers have cut back and now we are back to our old ways, amazing. Third – while sales are up this month and up from last year, they are still below 2008/2007/2006 levels and barely above 2005 levels. As much as I hate to admit it but if retail sales actually catch up to 2006/2007/2008, you could see retails stocks rally even further than they already have. I am still amazed that we are even at 2005/2006 levels of consumption since the housing ATM is shut down but going back to point #1, our population is growing so that is probably a good explanation.
What does all this mean? I don’t know, it was just a quick look at the numbers. Clearly the economy has stopped free-falling and the consumer is gaining confidence. Whether this is just a pause before a double-dip or the consumer is deluding himself, we will have to see. I have cut back my shorts by 50% for the umpteenth time and I have been looking for crappy retailers that haven’t rallied as hard and possibly don’t have alot of debt. I hate buying this junk (such as Movado, Nautilus, AC Moore, and Zales) but the trend is up and I am just renting these stocks for days/weeks. I still think too many analysts are behind the curve on earnings (look at Intel) so until analysts catch up, expectations are still too low. I am looking for Q310 or Q410 to finally see analysts get too bullish. The media might be bullish but not the analysts (yet).”
By the way – the last post was by a different Chris than the one bullish on financials.
i was going to call you the cap C chris
While it’s hard to dispute that retail sales have improved I have to wonder how much of this was due to the “Making Work Pay” tax credit of $400 per person if they had earned income (wages, schedule C, etc). All anyone filing a tax return needed was $6,451 of earned income to get the full $400 ADDITIONAL refund. Since most people don’t like paying when filing a tax return they deliberately adjust their withholding so as to get a refund. Most people I know didn’t realize this was coming. So, if you were single you received an additional $400 for your federal tax refund. Married filing joint, (assuming both had jobs for at least part of the year) make that $800.
Since this is a one time event, these retail sales may not look so good in the not to distant future and in my opinion retail sales have clearly been juiced over the last couple months by this extra $400 ‘gift’.
The Make Work Pay federal tax credit was immediately taxed back by the state here in California. It was essentially a mini backdoor bailout. I don’t know about other states.
Not so in Ohio. A $400 credit stayed as a $400 credit – no tax back.. I really can’t comment on CA. since I never looked into it nor did I do any CA returns.
I guess my point was that when considering the early Easter plus the $400 per taxpayer refund (probably received in March or Early April, retail sales were quite good and they should have been good. Most people I’ve seen use their tax refund for something and don’t save all that much of it. The bulls might be surprised (disappointedly so) come May.
This Retail Story is very interesting:
For your consideration : In the Twilight Zone
Both JPMorgan and BoA continue to record losses in their mortgage portfolio and revovlving debt/credit card portfolio.
Looks like the consumer is buying at retail and telling the banks to shove-it on the mortgage–
What can the bank do?? foreclose–the bank would have to TAKE THE LOSS!
Remember the banks have the mortgages on the books at “ORIGINAL VALUE” not what they are worth.
Remember IF the banks “right down” their collateral they become MORE INSOLVENT then they allready are!
Does the Consumer have “The Banks” by the “Balls” methinks they do and more and more consumers are getting this message.
A virtuous circle in the wrong direction.
Back to the Stockmarket
The Market is having a wonderfull earnings “Food Fight” reminds me of the movie Animal House.
The Intermediate-Term momentum metric I use is off the charts–The moves off the 2003 and 2009 lows look like a couple of “Dagmars” you old timers know what i’m talking about.
Going into an unfavorable seasonal time for the stockmarket–retail investors should consider protective stops.
How about people that strategically default on their mortgages or mortgages reworked with reduced principal and monthly payments. That’s money free up to be spend.
TPC,
Excellent post. Two Qs:
1) Given the underlying macro support for the economy/market, are you shorting for a minor correction in retail on the disconnect?
2) Since most retail investors have not yet jumped aboard this rally, doesn’t that scare you if they start chasing? The boomers have a LOT of ground to make up.
Thanks,
Damien
Hey Damien.
I am still constructive on the economy. But we’ve overheated in the near-term. So minor correction. I am still of the mindset that this is not a major market top.
The GS news is interesting though. This could snowball into rumors that the Volcker Rule is back on the table. It’s hard to imagine that the public won’t demand this…
Retail will be slow to move. They’re creeping in, but in the near-term this is not a concern of mine….
Love your work. Wish I had more time to read it. Have a great weekend.
TPC,
I agree with your thoughts.
BTW: I see the Goldman news as ultimately being more market constructive as it was when Skilling et al went to prison. That sets the stage for the final stage of a market when the retail investors feel safe and cozy. However, this could take a while to develop. $1000/hr attorneys will drag it out for the obvious reason
Love your work too. I also wish I had more time to read it. We are living parallel lives
All the best,
Damien
TPC, you were right. You were just early. Hopefully this pullback will be enough to at least get us both even.
Well said with astute points.
I too have been net short and nursing my wounds. This rally feels more like Jan/Feb 2000 where “it’s different this time” and “valuation doesn’t matter” mantras. Fed is adding more fuel to this bubble and the show may come to an end especially with exorbitant rise especially since late Feb.
TPC,
I concur! The positive: I was lucky that I went to cash in my entire portfolio after only loosing +-5%. I’m not a strategist, but am thankful someone, somewhere was looking out for me at the time. Now, here is where the negative begins: I never got back in. I have sited the EXACT same concerns as you have listed above. I have succumbed to believe that this market is 95% propped up by the banks, investment houses and primary dealers prop desks. Bottom line, I just don’t see any REAL improvements in the areas of the financial system that caused this melt down.
Has anyone out there been paying attention to the level of residential foreclosures that have been steadily mounting (and aggressively increasing mom) that soon will come to the market? I saw on CNBC where Steve L. interviewed some guy in the Government that was involved with the banking system. He stated that the banks are in so much better shape than they had anticipated at the time the stress tests were implemented. Doesn’t this have something to do with the fact that the banks are NOT recognizing the losses to the assets on their books that are backing up their loans? There are also billions of dollars lost in 2nd mortgages that none of these banks have recognized. I mean I just don’t get it? I get the feeling that our banking system is still insolvent.
I mean look at the sell off today over this Goldman deal. It won’t have any direct impact on the economy. These traders are like a hunter on their first hunt. They sleep with their finger on the trigger. Just salivating to pull the trigger at the thought of any movement in the weeds.
This Goldman deal could very well be the psychological event that causes the first domino to fall. I’m not sure if I’ll get the guts to put my hard earned money back to work in the stock market. Then you have to ask yourself, well what the hell do I do with my money? Maybe the ostrich market will make a come back? Who knows?
but but i thought the mkts only went up
given all the govt spending that’s taken place, we better have an uptick in the data. it’s just not sustainable for much longer.
Here are some anecdotal cases of strategic defaults and the increase spending. I posted before that these marginal spenders are giving the illusions of stronger demand than the actual organic demand out there.
http://www.nakedcapitalism.com/2010/04/strategic-defaults-increase-consumer-spending.html#comments
If you think about, it makes perfect sense. When someone opts for the strategic default and receives a rent hiatus they feel a sense of “winning”.
Rationally, they should be banking the money for a rainy day – which could be around the corner since most of these folks have little in the way of savings or assets that the bank/lender could come after.
Emotionally, the money saved is “free” or “won” and very much like hitting a trifecta on the ponies, or a $5000 scratch off lottery winner. Easy come, easy go.
I read these posts and I think what a pathetic crowd. It reminds me of watching episodes of “Sydney Riley: Ace of Spies” where the main character is an English double agent. It didn’t matter if he worked for the Bolsheviks, Brits, Germans or any other country as long as his fee was paid. He ultimately didn’t care one way or another how history was written as long as he made money.
This country truly is going to “hell in a hand basket”.
This is a bit off topic and maybe a little trite, but I have read two posts where you refer to a “Goldilocks” recovery. It has driven me crazy for years when Kudlow refers to a “Goldilocks” economy. I had to wonder if he ever read the story. It is about a person who violates someone’s private property and steals from them. Depending on the version, that person is either expelled or killed at the end of the story. How does that make the adjective “Goldilocks” positive. The misuse of this metaphor is enervating to your otherwise excellent writing. (IMHO)