* The following is an alternative view to an article Cullen Roche posted the other day.
By Chris Lynn, Writings on Wall Street
The Pragmatic Capitalism blog is excellent. I make it a part of my list of daily reading material and mostly agree with the opinions presented by Cullen Roche—the blog’s author. Although I find yesterday’s post about the “key question about the stock market’s rise” (click here for the post) to be very thought provoking, I do take the opposing view. Basically, Cullen dismissed the notion that the market is rising now due to an expectation of a further round of QE (stimulus), rather believing the following:
First, I don’t think the market is pricing in a recession, because, as Wall Street’s GDP consensus for the next few quarters clearly shows, a recession isn’t expected. But more importantly, equity prices in the USA are primarily a function of corporate profits and even though there are signs of deterioration in profits neither the Euro crisis nor signs of deterioration in the US economy has actually led to a signification decline in profits… And until we begin to see significant deterioration in the profit picture we’re unlikely to see significant deterioration in the equity markets.
To this I disagree. First of all, stock prices are discounting mechanisms. This means that the price of a stock today reflects future cash flows. The uncertainty with a current stock price is that the future cash flows are unknown. We can make assumptions based on the company’s history, economic history, & company positioning, but uncertainty still exists. It’s unavoidable. What’s also true is that the current profit picture is mostlyinsignificant. In other words, the fact that companies have booked profits yesterday should not impact the stock price today. The good & bad news for stocks is that they are extremely sensitive to what the future holds. And through the power of discounting future cash flows out many years, it is empirically possible for only a hint of better times in the future to result in healthy gains in the present. The stock market does this with much more precision and efficiency than other asset classes such as real estate. This helps explain why the S&P is within a spitting distance of its all-time high while the real estate market is at least a half-marathon away. Unfortunately, the inverse holds just as much. In other words, stocks will do poorly if they sense a sustained future economic degradation.
As I’ve argued that current profits are mostly insignificant, at times they can reveal future expectations. Yesterday, on my blog, I linked to an article showing data that companies are increasing their bottom line profits, but not their top line sales. In other words, cost cutting is driving profits. In one way this is beneficial because it shows the resiliency of the American corporation. However, there is only so much fat that can be cut. Eventually, stocks will need sales growth to continue any upside. And to me, because of the way a current stock price is a mere reflection of its future cash flows, I’m not sure how the rationale investor can pay a higher price for a stock given the sales growth problem and, more importantly, the tremendous uncertainty about the macroeconomic picture. No, it makes more sense to me that QE should be given most of the credit of the stock run-up–at least for now.
Some of the greatest investors of our time have asserted that the market is not always efficient. George Soros, William O’Neil and even Eugene Fama himself have dismissed the idea of market efficiency in one way or another. Soros’ theory of “reflexivity” is a commentary on the human capacity to change events by taking actions ahead of perceived expectations (that are inherently flawed) only to distort the outcomes expected in the first place. So, the expectation that QE will lead to higher stock prices—no matter if the premise is inherently flawed or not—can lead to higher stock prices. In other words, higher stock prices beget higher stock prices. It only takes this perception.
The following chart seems to suggest that past QE stimulus has successfully propped up markets. Whether warranted or not, it seems to be the perception. If that is indeed the perception, then one can conclude that future QE (or even the hope of future QE) could be providing the same type of impact in the face of severe economic uncertainty.
I think that Cullen, John Hussman (who is quoted in Cullen’s blog) and I would agree that fundamental earnings do drive stock prices over the long term, but I would have to say that markets can be sustained by perceptions that might not be real over certain periods. I think we’re in one of those now.