Markets don’t care about fundamentals anymore, but why?
We all know or have a feeling that our economy is no longer an economy, but more of a balloon that inflates and deflates depending on how much air the Federal Reserve decides to pump in.
Right now, the most powerful central bank needs a sizeable cannister as economic indicators continue to show poor readings: The world’s most influential PMI, the Institute for Supply Management’s Report on Business (ISM), points to contraction at 47.2, freight volumes are down, year on year, every month for the past two years, and even the most lagging of economic indicators like jobless claims are in a bearish trend moving into the new decade.
As the U.S economy continues to falter, a decline in global economic activity continues to emerge: Germany has narrowly avoided recession after posting -0.2% and 0.1% GDP growth in respective quarters. The Chinese economy is experiencing hiccups as financial institutions continue to be bailed out and taken over by authorities, and the U.K narrowly avoided recession despite delaying a “no-deal” Brexit.
But if leading indicators are pointing to a global economic contraction, why are stock markets — the most reactionary markets in the world — still climbing to all-time highs? Quite simply, they are no longer a barometer for economic fundamentals.
This is evident by reviewing any popular metric used to value — or predict the future value of — a stock. Take earnings growth, for example. This once-reliable metric used by many in finance has become inconsequential: According to a recent FactSet report, the EPS growth of S&P500 companies in 2020 is set to decline by 1.4%. The biggest weighting of the index, Apple, is the poster child achieving no increase in earnings growth for over a year. But despite that, the tech giant’s stock price continues to climb higher. Price-earnings (PE) ratios also tell a similar story. The mind-boggling valuations of companies like Square and AMD that sport PE ratios of at least 200 times, remain in high demand and the market still deems them to be cheap.
So if fundamentals are out of fashion, what’s the new trend driving stock markets higher? The truth is the stock market is no longer a barometer for the value of companies, instead, its a barometer for liquidity within the financial system, and, right now, there’s an excess supply.
To counter the poor global economic data, Federal Reserve Chair, Jerome Powell, announced recently that the Fed will continue to prop up markets in 2020 by injecting billions of dollars, daily, into the financial system. And although he insists it’s not QE (quantitative easing), in reality, it’s a repeat of the same process: the rapid re-expansion of the Federal Reserve’s balance sheet. Admitting that “Not QE” is, in fact, QE, may panic investors triggering a bit of Déjà vu reminding them of the Fed’s response to the threat of a global collapse during the Great Recession. For now, though, the Fed has successfully duped the market into believing it’s a way to help out in the short term, but without long term assistance, the inputs holding the market together will not function.
The liquidity “Not QE” provides, enables public companies to inflate their earnings, therefore, inflating their stock price. By buying their own stock in the open market — commonly known as share buybacks — this once illegal practice has contributed to some of the biggest stock market bubbles in recent history. It allows any company on the verge of negative earnings to borrow money and buy a part of their company, masking the damage of any short term economic downturn.
That’s not all, though, as buybacks have a partner in crime when it comes to stock manipulation: Algorithms designed for the sole purpose of trading stocks on news headlines, analyze press releases of “trade deal optimism”. Whether the initial story was real or fake, trades executed by computer algorithms can add several hundred points to the Dow Jones in a matter of seconds. What’s more remarkable, though, is the correlation between news around “trade deal optimism” and short term rallies.
Politics is always at the center of most stock market bubbles which are more likely to form when a President has an attraction to ultra-low interest rates such as Trump — it’s a real estate tycoon’s dream. Every time the stock market falls to an unsatisfactory level, the President protests, and the Federal Reserve lowers rates. The consistent decline in interest rates creates an increasingly cheaper financial environment, enabling almost anyone to take out cheap loans and buy stocks they can’t afford outright, increasing the size of the bubble further.
While this is happening, Trump insists we have the greatest economy ever, but this is, in fact, a euphemism for the highest stock market ever. Though, a booming stock market does not equal a booming economy. You have to ask the obvious question: Why would you have to lower rates when everything is good? How can it be the greatest economy ever when the Fed is providing daily support and announcing rate cuts at all their recent meetings except one? When you remove all the non-fundamental inputs: the liquidity, the algos, the money printing, the cheap credit, the politics, who’s left to support the stock market? The answer is the people, but we’ve already hit peak optimism. Who’s next in line to buy?
This is our situation: an economy based on maintaining liquidity to prop up asset prices instead of trying to create real, organic growth. It’s been the status quo for so long that, ultimately, we have embraced it as a collective. We are entering a yoyo situation: an up and down economy where we create temporary growth and face the consequences of our actions in the future. As long as irrationality in the form of overvalued stocks, bonds, and real estate, continues to be a moneymaker, we’ll stand by this system through endless booms and busts despite the end result always being the same: another financial crisis. The bankruptcies, the delinquencies, the disparities, the misallocation of resources, the inequalities, and the ever-increasing size of the wealth gap are ignored in favor of unrealized profits.
What’s scarier, though, is the people in power are unwilling to accept that economies fix their imbalances at some point in time. They will never drop the strong economy narrative even when economic data shows otherwise, because, simply, its political suicide. If our leaders truly believe we have the best economy ever while, in reality, we’re on the brink of collapse, a weak economy is something sinister; a situation we all want to avoid, but we all know is coming.
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