While there is still plenty of time for the bears to get their act together, so far at least, the month of September has made the doom-and-gloomers feel more than a little silly. As of Friday’s close, the S&P 500 finds itself up +4.67% for the month while the Dow sports a gain of +3.41%, the NASDAQ is up +6.16%, and the Russell 2000 has enjoyed an advance of +8.01%.
What must be truly maddening to our furry friends is this was supposed to be their time. History (and the Stock Trader’s Almanac) shows plainly that September and October are the worst two months of the year for the stock market. And with last year’s debacle still fresh in the minds of investors, those in the bear camp probably came into the month licking their chops.
But a funny thing happened on the way to the correction so far this month. It seems that better earnings guidance and some hope that corporate America might (and we’d like to stress the use of the word ‘might’) see some top line growth in the upcoming earnings season has turned the tables on the bears. In English, what we’re saying is that while ‘cost cutting’ was widely attributed for second quarter earnings coming in above expectations, the current whisper on the street is that we might actually see some, dare I say it, revenue growth out of companies in the current quarter.
Please understand that we are not expressing an opinion on the subject of revenue growth nor are we presenting an argument for such an event. We are by no means experts on assessing the earnings outlook for 500 different companies. No, our job, as we’ve mentioned a time or three, is to make sure we understand what is driving the market at any given time. So, with a great many investors scratching their heads over why the stock market has gone straight up during what is supposed to be a miserable month, we thought it would be a good idea to make sure everyone understands why the run for the roses is taking place from a near term perspective.
Speaking of head scratching, in discussions with a handful people recently, the question of why the market continues to head higher usually is the first subject we address. One of the major ‘big-picture’ themes being offered by my friends these days is that stocks shouldn’t be able to head higher because they’ve already run 58% off the low. And as such, the question asked is: Isn’t that enough to discount an economic recovery that is likely to be weak?
After some admonishment for the use of the word ‘should’ (remember, the words ‘should, could, and would’ are never allowed to be used in the business of understanding the machinations of the market) and the usual caveat that Ms. Market can do whatever she darn well pleases, I find myself going back to the big-picture concept of the market being a discounting mechanism to make my points.
While my views are merely my own and could very easily be flawed, I’ve created some very rudimentary charts to illustrate my view of the world. From my perspective, if you can understand what the market is doing from a big-picture standpoint, it tends to cause much less consternation when things don’t go as expected in the near-term.
The month of September is a perfect example of this point. Most everybody on the planet will agree that stocks are overbought and due for a pullback. Yet, stocks have shown no interest in “correcting” and have simply marched higher. As we pointed out earlier, we believe that this is occurring because (1) some earnings guidance that has been better than expected, (2) growing expectations that we might start seeing revenue growth from companies in the near future, and (3) performance anxiety among fund managers charged with keeping up with the Joneses (er, the S&P 500).
While this near-term explanation may (or may not) make sense to some, it doesn’t necessarily explain the big-picture issue of stocks charging higher to the tune of 58% in just 6 months, which, I’m told, is the fastest rate of advance since the 1930’s.
The point that my less-than upbeat colleagues like to make is that stocks are becoming delusional about the future and that “enough is enough already” in terms of the 58% jaunt to the upside.
The first major counterpoint to this objection is that putting a label on how much is “enough” is a dangerous game. Remember, the stock market doesn’t give a hoot about what we think is right or wrong. And as Ned Davis so eloquently wrote years ago, this game isn’t about being right, it’s about making money.
So without further ado, I’d like to present my view of what has happened over the past year and what I believe I am seeing now.
Take a look at the chart below. Yes, I will admit that my skills with editing a chart leave a lot to be desired and I apologize for the elementary effort. But, I have managed to label two areas that I think are important in understanding where we’ve been and where we’re going.
The Credit Crisis
The first period I’ve labeled is “The Credit Crisis.” This is the period where the stock market finally noticed that there was a problem – a big problem. And as we all know, things proceeded to quickly fell apart at the seams during September through November.
However, after a quick dip of -42% from the end of August 2008 through November 20th, the market began to recover. Thus, we will argue that stocks spent the period from November 21st through January 6th digesting (or discounting) the new world. And since stocks appeared to have stabilized during that period, we will suggest that the decline of -42% was considered to be enough to “discount” the expectations for the future.
However, this was BEFORE we started to recognize how much damage the seizure in the credit markets was inflicting on the banks and the BEFORE we understood the consequences of Lehman’s bankruptcy.
As it became clear that the banks, investment banks, and insurance companies had NOT “kitchen sinked” their earnings reports in terms of their total writedowns during the third and fourth quarter, analysts started doing the math on the losses. And in short, it looked like our banking system was on the verge of becoming technically insolvent.
Yes, much of the problem had to do with the fact that those toxic assets nobody was regulating weren’t trading and that the mark-to-market accounting rules meant that financial institutions had to use fire-sale trades as the current prices on their books. But the bottom line is that talk of nationalizing the banking system was becoming louder and began to look like a distinct possibility.
This brings us to the second label on the chart: Financial Armageddon. Our view is that the decline from January 6th through March 9th represented a “discounting” of the potential problems in our banking system. While I am likely to encounter some disagreement on this topic, I believe that -27.8% fall from January 6, 2009 through March 9th was based primarily on the concept of our financial system collapsing – or what has come to be known as the Financial Armageddon discount.
From there, we got a change in the FASB mark-to-market rules (why this wasn’t done sooner still boggles the mind) and we got word that the Fed’s massive intervention was having an effect. As you will recall, the very moment we heard Jamie Dimon say that his firm is actually making money, things turned around – and the indices haven’t looked back since.
So, with the concept of the banking system collapsing now off the table, traders quickly went to work on “undoing” the Armageddon discount. Thus, it is my humble opinion that the move up from March 10, 2009 to the first pause in the indices, which began on May 8th, represented the removal of the -28% discount that had been applied during the first two-plus months of the year. I’ve labeled this move as the “Banks Will Survive” discount on the chart below.
Discounting the Future
The market then proceeded to basically move sideways from May into the early part of July. While it had become clear that the banking system would survive, the outlook for the economy remained a big question mark. Which, again, in our humble opinion, was the reason for the two-month pause.
However, in July, we started to see improvement in the economic indicators. And while the argument still rages on about the actual degree of improvement involved and the underlying reasons for the improvement, the bottom line is the indicators suggested that the recession was ending.
As more and more economic reports came in a little better than had been expected, the stock market continued to do its job as a discounting mechanism. Thus, we will propose that the rebound in the S&P of +21% from the July lows represents the discounting of the idea that the economy will rebound.
Which brings us to the present. While we obviously reserve the right to be wrong, we will offer that we are now moving into the next phase of the discounting game. And while there is no label yet on the graphs, we’ll call this the phase of discounting economic recovery expectations.
At this stage of the game the consensus is that the economic recovery will be weak. So, anything that might suggest otherwise could be met with some additional “discounting” to the upside and vice versa. Thus, we believe that from here, stocks will need to see improvement in earnings and actual improvement in the economy (some job growth would be nice) in order for stocks to advance significantly.
So, now that we’re up to speed on the discounting game, be sure to stay tuned, because this game is far from over and the outcome isn’t exactly assured.