Financial Market Commentary

This article provides a snapshot of the best- and worst-performing US stock sectors in 2011. The classic defensive sectors — Utilities, Consumer Staples and Health Care — started the year on a positive note, began outperforming following the market’s February decline, and assumed full market leadership after the August market meltdown. These sectors ended the year with total returns of 13%, 11% and 10%, respectively.

Tightly-packed around mediocrity, with returns ranging from +4% to -2%, were the Consumer Discretionary, Energy, Technology and Industrial sectors. These sectors are the ones that would be expected to lead in a more vigorous economic expansion, which was conspicuously absent after being widely-touted by most pundits early in 2011. The graph below shows how these sectors led the way early in the year, but were eventually overtaken by the classic defensive sectors.

And, rounding out the field with total returns ranging from -11% to -18%, were the Telecom, Financial and Materials sectors, battered by competition, malfeasance and incompetence, and an abrupt shift to “risk-off” mode following the August meltdown, respectively.

After publishing an analysis of the Conference Board’s Economic Indicators and 2012 Economic Outlook later this week, I will opine on which sectors are likely to lead the way in early 2012. Stay tuned.

Datasource: Capital IQ

David Sowerby of Loomis Sayles gave an interview on CNBC last Friday (12.16.11, video available here). Mr. Sowerby cited the following reason for being bullish on stocks:

. . . if you look at the continued improvement in cash flow margins, that are about 20% today for most companies, still below the 24% peak levels for 2007, I think too many investors are focused on net profit margins, not focused on the statement of cash flows, that’s what can get stock prices higher . . .

Twenty percent free cash flow margin sounded a little high to me, so I decided to take a closer look. I calculated the equally-weighted and capitalization-weighted gross, net, and unlevered free cash flow margins for the S&P 500 from 1994-2011. The graph below shows that the average gross margin expanded dramatically from 1994-2000, after which it levels off and drifts slightly higher. Cap-weighting makes a difference, as large-cap firms have higher gross margins. I found it interesting that gross margins were largely unaffected by the 2000-2001 and 2007-2009 recessions:

Health Care, Telecom and Information Technology have the highest cap-weighted gross margins. Health Care’s cap-weighted gross margin now exceeds 60%:

Average net margins are also trending upwards, although net margins display pronounced declines during the last two recessions. Cap-weighting once again makes a difference, as larger-cap companies earn higher net margins. Further note how the cap-weighted series shows less of a decline during recessions.

The Health Care and Information Technology sectors also have the highest cap-weighted net margins, along with — surprise — Financial stocks. Notice how, until their demise in 2007, Financials squeezed the highest net margins out of their revenues compared with the rest of the S&P 500:

I also calculated the equally-weighted and cap-weighted unlevered free cash flow margin for the S&P 500, depicted in the graph below.

Mr. Sayles definitely gets a few things right. Unlevered free cash flow margins have been in an 18-year uptrend, and the equally-weighted series does indeed peak in 2007. Cap-weighting makes more sense, however, as an equally-weighted series places disproportionate weight on the margins of smaller firms. The graph above shows that the mean cap-weighted free cash flow margin of the S&P 500 is at an 18-year high.

The sectors with the highest cap-weighted unlevered free cash flow margins are once again Health Care, Telecom and Information Technology, ranging between 13%-18%:

Conclusion: S&P 500 gross, net, and unlevered free cash flow margins trend upwards from 1994-2011. Health Care has the highest gross and unlevered free cash flow margin, followed by Telecom and Information Technology. Surprisingly, Financial stocks’ net margins have rebounded sharply.

The mean cap-weighted unlevered free cash flow margin for the S&P 500 is only 12.2%, however, much lower than Mr. Sowerby’s estimate of 20%. One possible explanation for the difference in our findings is that the Loomis Sayles calculations refer to levered free cash flow margin, which we would expect to be higher. I propose that cap-weighted unlevered free cash flow margin is a better measure, however. Levered FCF arbitrarily places more weight on the margins of firms that use more debt, instead of weighting by the more traditional market cap factor.

Datasource: Capital IQ.

My first contribution to the end-of-year market outlook season is a big-picture view of the S&P 500 (in billions, and percent where applicable). The market capitalization of all 500 stocks still lags its 2007 level, but total revenues and profits hit all-time highs in 2011:

Those record profits have not induced firms to restore payouts to shareholders, however. Dividends and repurchases remain at their depressed levels from 2008-2009:

Aggregating across all firms, I created pseudo price/earnings, price/sales, and price/book ratios for the S&P 500. The slow mean reversion of US stocks’ relative valuation is evident in the graph below. The ratio of Market Cap/Net Income (or P/E) of the S&P 500 = 13.3, the lowest it has been in 20 years:

As shown in the next chart, stocks’ earnings yield is 7.5%, the highest in a generation. Firms’ dividend yield remains stuck at 2.1%, however, and the dividend plus repurchase yield is only 3.2%:

Stocks are gradually becoming cheaper. Investors have apparently remembered the long-forgotten concept of the risk premium. Cheap stocks beget bull markets (1982), but overpriced stocks beget wailing and gnashing of teeth (1999). Valuations are re-setting. The process takes an agonizingly long time, but it’s happening, and from the look of things, we’re almost there.

But cheap stocks are not enough to make a bull market; stocks need to be cheap relative to the underlying companies’ future prospects. And there’s one key signal that has yet to flash “go” for US equities: corporate boards have let dividend payouts lag far behind their historical relation with earnings. Below I’ve graphed the historical spread between stocks’ earnings yield and dividend yield. The 2011 spread of 5.4% is quite high by historical standards:

Of course, finance theory proposes that executives’ reluctance to increase payouts in proportion with earnings signals their lack of confidence that recent profit levels are permanently sustainable (Weigand and Baker, 2009 and Fargher and Weigand, 2009). Until firms raise dividends enough to increase yields, markets have no reason to believe that the incredible profit surge from 2010-2011 is the real deal. Instead of jawboning about business confidence, boards should simply pull the trigger and raise dividends decisively.

– Data from S&P’s Capital IQ

I have always been intrigued with investors’ reliance on the Conference Board’s Leading Economic Indicators (LEI), despite the fact that few can thoughtfully interpret (or even identify) the most heavily-weighted components (the first 4 account for almost 80% of the LEI’s behavior). In a recent Forbes article, Ken Fisher (a.k.a. the advisor with a strong track record of crying “bull” at the worst possible moment) informs us:

. . . another recession now would be unprecedented when you consider the historical evidence. We have never had a recession after the traditional leading economic indicator (LEI) index has been high and rising for five months . . .

Sounds like an invitation to take a closer look. Let’s examine the most heavily-weighted component of the LEI (weighted 35%), the growth rate of the M2 Money Supply. The inflation-adjusted series is graphed along with Real Business and Consumer Loans:

Paradoxically, the main justification for the aggressive expansion of the US Money Supply has been to spur lending during a period of market-mandated de-leveraging, which has always struck me as odd. As the graph shows, the Total Consumer Loans series continues trending downward, while the Total Business Loans series has risen slightly in 2011. Overall, however, there has been little positive impact on borrowing, mainly confined to the business side.

All is not lost, of course — the economy could still receive a boost if consumers were simply spending all that loose money, as measured by the velocity (or turnover) of the M2 Money Stock. The chart below depicts nominal M2 and the Velocity of M2:

The news from the Velocity series is hardly encouraging — the Velocity of Money has been in a downtrend since 2000, and is lower than it’s been at any time during the last recession. While the most heavily-weighted LEI component has been rising in recent years, this rise is solely due to artificial intervention by the Fed. No positive market response to all this loose money is evident in borrowing or spending.

Let’s take a look at the second most heavily-weighted LEI component, the Average Length of the Manufacturing Workweek, weighted around 26%. This series is depicted in the graph below. The Average Length of the Construction Workweek is also shown:

Both series are flashing positive signals. The Manufacturing Workweek is even slightly longer than it was pre-recession. Of course, focusing on the number of hours worked by those who remain employed allows for a positive interpretation that conveniently overlooks the information conveyed by the next graph, which shows Total Employment in Manufacturing and Construction:

Call me crazy, but I can’t understand how the fact that 3 million fewer manufacturing employees and 2 million fewer construction employees are working the same number of hours forecasts economic growth. Stabilization around a lower level of economic activity would be a more accurate interpretation. Moreover, these 2 variables account for over 60% of the entire LEI.

We’re on a roll now, so let’s take a look at the third most heavily-weighted LEI component (10%), the spread between the yield on the 10-year T-note and the Fed Funds Rate, shown in the graph below:

This series is really a proxy for the slope of the yield curve, where an upward-sloping curve implies economic expansion, and a flattening or inverting of the curve implies slowdown or contraction. Two key points here. First, the graph shows that the curve has been flattening throughout 2011, accurately foretelling the slowing economy in which we find ourselves. Second, as pointed out in a thoughtful article by Chris Turner via Advisor Perspectives, domestic and global Central Bank intervention has made it impossible to know (or even guess) what market-determined interest rates would or should be anymore.

Thus far we’ve accounted for 70% of the magical, mystical LEI index, and on this more granular level, it’s difficult to see the unequivocally positive information that is so apparent to bulls like Ken Fisher.

Still not convinced? Okay — let’s take a look at indicator number four, Manufacturer’s New Orders for Consumer Goods, weighted almost 8% in the LEI index. If we consider the change in the nominal series, the signal appears positive:

The series displays an impressive rebound since its recessionary plunge. Maybe there is some good news here; after all, consumers have been spending as of late, and Black Friday expectations are high. Before we get too excited, however, let’s take a look at the same series adjusted for inflation:

Ah, inflation, that silent thief, working its nefarious black magic over long horizons . . . the series is far less exciting when viewed in real terms. Non-Defense Durable Goods Orders are almost back up to their 2002 post-recessionary lows. With a little luck, we might soon be back where we were . . . 10 years ago.

Having accounted for almost 80% of the LEI, I rest my case. Ken Fisher’s exhortations notwithstanding, the LEI appears to be flashing positive signals because, like most averages, it obscures those always-devilish details. The economy has slowed and continues to slow. Unless businesses lay off even more workers to further boost profits, or stock valuations simply continue to ignore fundamental information, stocks may face considerable headwinds in 2012.

The graph says it all. Ronald Reagan ushered in a low-tax, anti-regulation, big deficit, pro-business philosophy that gradually spilled over to the corporate and household sectors and . . . did not work as advertised. Below I’ve charted the year-over-year change in US GDP since 1948. (Data provided by the Federal Reserve Economic Database. You can download the data by clicking here.)

Economic growth has been slowing in the US for 30 years. Let’s all grasp this simple fact. Furthermore, marginal tax rates have been decreasing over the same 30 year period, which leads to simple fact #2: reducing tax rates did not make the economy grow faster.

Where do we go from here? In the intermediate term, dramatic cutbacks in federal spending, along with further reductions in consumer spending (driven by high unemployment, and well-founded fears of dysfunctional federal government planning to reduce citizen’s Social Security and Medicare benefits), are likely to further slow GDP growth over the next several years — and maybe longer. Beware of purveyors of equities touting the boost the consumer will receive from lower energy prices. (The minute there’s institutional bullishness, oil will surge.)

Ongoing deleveraging will further slow growth, as will limits on money-printing stimulus programs designed to debase the US dollar (a lower dollar makes net exports less negative, which is positive for GDP). Japan’s assertive intervention on behalf of the yen today (August 4) got markets off to a skittish start, and the US has already used up a lot of its currency-debasing arsenal. Japan is ready to race us to the bottom, and a falling US dollar was a significant catalyst for rising US equities in 2010-2011. Many was the day when the trade was “dollar down, stocks up.”

In my humble opinion, it’s risk-off for quite awhile, unless you’re nimble enough to catch falling knives, among other feats of bravery that will be required to wade into equities on Friday, August 5. If you’re a buy-and-hold dividend investor like myself, it won’t be safe to come up for air (significantly increase long-term exposure to US equities) until the market finishes pricing the European crisis du jour and fully grasps the low-growth scenario the US has been slip-sliding into for 30 years — and is likely to remain mired in for as long as the rest of this decade. Given investors’ highly-refined ability to shrug off negative economic news, fully pricing in how close to Japan we’ve become could take some time (remember, on Aug. 4 we learned that Japan perceives that they’re in all-out currency debasement war with us).

Where to hide? I believe that gold is your friend. There are dark days ahead, and eventually everyone shall seek shelter there. Riding the gold bubble might be the new AAPL-GOOG-AMZN-NFLX-BIDU auto-trade for awhile. (But the risks are huge: just remember what the Fed did to silver earlier this summer by arbitrariliy raising margin requirements. The capricious hand of government lurks everywhere.)

Good luck, I’m interested in hearing how everyone did on Thursday. (Disclosure: Long GLD.)

I came across a thoughtful article from Automatic Earth recently. Although the article might appear a little off-beat, referencing “black holes” and whatnot, it’s actually right on the mark.

The comparison between the concept of “time dilation” in Einsteinian relativity and finance is very apt. Countries with more sophisticated financial structures provide businesses and individuals with greater options for “time-shifting” consumption via the financial system. Citizens in the US suffer less than citizens in Tunisia (for example) because we can use our  financial system (on the government and individual level) to get more of what we need now (even though we really can’t pay for it in the long run). A Tunisian, on the other hand, has to focus on finding food and water today. Tunisians live closer to the “real” (physical, tangible) economy, whereas Americans live further away from issues directly pertaining to food and water, thanks to our access to credit and government giveaways (financed by borrowing on the government level).

It becomes increasingly difficult for citizens to distinguish the “real” economy from the “financial” economy the longer they live in the latter and are separated from the former. The Adam Smith tenets of capitalism pertain to the real economy, but in the US and other “sophisticated” nations, we’ve gradually substituted “financialization” for real economic activity to the point that virtually everyone confuses the two.

Consider the simple notion of net present value (NPV), the bottom-line of Adam Smith-style capitalism. A business or individual gathers real resources (the financial system only provides capital for this, it’s a supporting activity) and recombines these resources so that they are worth more than the sum of their parts (taking the time value of money into account). When this is done successfully, what we call “the economy” expands, and the aggregate general welfare of mankind improves (although some individuals may be worse off).

The main point of this short article is that we (and especially the Bernank) have deeply confused the beneficial kind of Adam Smith capitalist wealth creation with the illusory wealth created by the financial system. The financial system is beneficial only in its supporting role to the real economy. But the profits earned via trading activities from the Goldman Sachs and JP Morgans of the world are not Adam Smith-style profits — the ones that grow the overall economy and improve the general welfare. These type of profits are instead ”zero-sum” profits. When Goldman wins on a trade, someone else loses the same amount. Moreover, the economic system is actually poorer because these zero-sum profits involve transaction costs, which means that all the Goldman/JP Morgan-type activities are actually negative NPV in the aggregate.

A key point from the Automatic Earth article is that “sophisticated” economies have increasingly moved towards these types of financialized business activities (thanks to the incredible political clout of the financial lobby) and moved away from Adam Smith-style real economy business activities. But, thanks to the ability to “time-shift” our consumption via the financial system, ”first-world” citizens enjoy a delayed reaction to the true cost of this shift. It’s out there, and we’ve got to face it eventually, but we instead keep choosing short-term fixes, the proverbial “kicking the can down the road,” which just makes the price we’ll have to pay even higher in the long run.

The bottom line: we can’t “financialize” our way out of anything. The financial sector may earn profits for themselves, but only the profits they earn via making productive business and consumer loans and investments truly grow the economy. Virtually all of their trading and M&A activities just reshuffle the deck, like a card sharp, so that at the end of the day the financial sector holds more face cards while the rest of us hold more twos and threes (and jokers!).

It’s therefore not enough to just grow the economy, but we also need to shrink the unproductive trading-based part of the financial sector so that in the long run real economic activity grows faster than zero-sum financial type activity. Until we get that point and act on it, we’re just spinning our wheels and sinking deeper into the mud of financialization.

The chart says it all. I graphed the inflation-adjusted S&P 500, using January 1991 = 0 as the base. Data courtesy of Robert Shiller (available for download here).

If the descending triple-top does not speak for itself, also bear in mind that the level of the S&P 500 is being deflated by the government-reported CPI, which is calculated with all those wacky hedonic adjustments, so the extent to which equity valuations have failed to keep up with inflation is actually understated by the graph. After inflation, the buy-and-hold investor has a portfolio that’s equal to its 1997 value.

I’m always interested in how markets react to technical indicators. In previous posts (July 14 and January 8), I’ve described how, in this bull cycle, equity markets have displayed a tendency to react to classic ”sell” indicators — as well as all negative news – with a bit of a lag, which is probably due to markets being a little juiced up on loose Fed policy.

Based on today’s price action, I’m wondering if the price of gold is overdue to react to its triple top from late 2010 through early 2011. Take a look at the GLD SPDR Gold Trust ETF over the past 6 months:

I’d say gold looks pretty triple-toppy between early November and early January. But investors forgive Gold’s neckline piercing as just a one night stand with risk — at least this time – and the bullish trend immediately resumes.

In the last 10 days, gold prices formed another almost/kind of-triple top, maybe a sloppy one, but failed to pierce the proverbial neckline (not yet, anyway – notice how investors knew right where the support level was today):

The point is that gold keeps flirting with a classic predictor of a correction, but shrugged it off earlier in 2011, similar to the way equity markets tried to do – at least for awhile. What many investors want to know is, does the recent price action suggest a good entry point for investors looking to initiate or add to long-term positions?

A 1-year chart of gold shows that it’s displayed a tendency to bounce off of previous lows and move sharply higher:

If gold bounces off previous support as it has done recently, $1,270-$1,280-ish looks like a safe entry point range for starting or adding to long-term positions. Keep an eye on short-term technicals to see if it will correct that low, however — markets have done a great job of shrugging off bad news in the last 2 years, and it’s not out of the question that we’ll rally on Friday off of Thursday’s price declines. If that happens, I recommend being patient and letting gold prices come back to you, just a little more at least.

One final point: it’s interesting to note that a price decline from recent highs would be pretty much right on the mark for a classic minimum correction threshold of -10%. I’d be a long-term buyer in the $1,270-$1,280 range.

Disclosure: Long GLD.

Is there anyone left out there who still believes that officially published inflation rates do not understate actual inflation? This morning I learned that gas and oil prices have been rising faster than the energy CPI for years — a result which fails to resonate with my common sense.

The chart below was constructed using data from FRED2. I took oil and gas prices, deflated each series by the official energy CPI, and marveled at the results.

Since 1994, gas prices have risen 2.8% per year faster than the energy CPI, and oil prices have risen 9.6% per year faster. Are gas and oil prices being hedonically “adjusted” (manipulated) downwards when incorporated into the energy CPI? Or are other components of the energy CPI deemed to be “better” each year, and thus deserving of hedonic adjustments? Electricity, perhaps?

In this column I will continue the theme of quoting Washington’s Farewell Address, this time on the topic of national unity and political partisanship. First, a summary of Washington’s thoughts on the importance of national unity and how to remain on guard against those who would compromise it, followed by an exact quotation of his own words.

1. Unity of government is important to the citizens of the United States because unity supports our independence, peace, safety, prosperity and liberty.
2. I can foresee, however, that many will employ mistruths, often covertly and indisiously, to weaken our conviction to preserving national unity.
3. It is of the utmost importance that we properly estimate the value of our national union, and develop the unwavering habit of preserving it; moreover, our collective efforts to do so should always be cordial.
4. We should disapprove of – to the point of embarrassing – those who would even suggest national unity is not necessary, or that any portion of our country or its citizens can be alienated from the rest.
5. Some will attempt to undermine our national unity by misrepresenting the opinions and goals of others; this is something from which you cannot shield yourself too much, as these mispresentations will make us feel alien to one another, when instead we should be fostering feelings of fraternal affection.
6. The alternate domination of one party over another, especially when sharpened by the spirit of revenge, is itself a frightful form of despotism, which gradually leads to a more formal and permanent despotism.
7. This despotism leads citizens to seek security by granting individuals absolute power; but leaders who would accept such power are only interested in elevating themselves at the expense of public liberty.

The exact quotations from Washington’s Farewell Address follow below:

The unity of government which constitutes you one people is also now dear to you. It is justly so, for it is a main pillar in the edifice of your real independence, the support of your tranquility at home, your peace abroad; of your safety; of your prosperity; of that very liberty which you so highly prize. But as it is easy to foresee that, from different causes and from different quarters, much pains will be taken, many artifices employed to weaken in your minds the conviction of this truth; as this is the point in your political fortress against which the batteries of internal and external enemies will be most constantly and actively (though often covertly and insidiously) directed, it is of infinite moment that you should properly estimate the immense value of your national union to your collective and individual happiness; that you should cherish a cordial, habitual, and immovable attachment to it; accustoming yourselves to think and speak of it as of the palladium of your political safety and prosperity; watching for its preservation with jealous anxiety; discountenancing whatever may suggest even a suspicion that it can in any event be abandoned; and indignantly frowning upon the first dawning of every attempt to alienate any portion of our country from the rest, or to enfeeble the sacred ties which now link together the various parts.

In contemplating the causes which may disturb our Union, it occurs as matter of serious concern that any ground should have been furnished for characterizing parties by geographical discriminations, Northern and Southern, Atlantic and Western; whence designing men may endeavor to excite a belief that there is a real difference of local interests and views. One of the expedients of party to acquire influence within particular districts is to misrepresent the opinions and aims of other districts. You cannot shield yourselves too much against the jealousies and heartburnings which spring from these misrepresentations; they tend to render alien to each other those who ought to be bound together by fraternal affection.

The alternate domination of one faction over another, sharpened by the spirit of revenge, natural to party dissension, which in different ages and countries has perpetrated the most horrid enormities, is itself a frightful despotism. But this leads at length to a more formal and permanent despotism. The disorders and miseries which result gradually incline the minds of men to seek security and repose in the absolute power of an individual; and sooner or later the chief of some prevailing faction, more able or more fortunate than his competitors, turns this disposition to the purposes of his own elevation, on the ruins of public liberty.

Jeremy Grantham’s missives are always must-reads, and his most recent “I Like Ike: A Powerful Warning Ignored,” is no exception (download from gmo.com with free registration, or Zero Hedge without registration).

For those of you who found Grantham’s review of Eisenhower’s warnings to our country interesting, I thought you might also enjoy a quick tour through some of the writings of the ultimate founding father: George Washington. Given that our current Congress has such an interest in our founding fathers’ intentions — exemplified by their reading the Constitution in their first session of the year — I suggest that they also read Washington’s Farewell Address (1796) out loud one of these days, as it contains additional advice our political leaders would undoubtedly find useful, given our country’s current circumstances.

For those of you who in a hurry, here’s a synopsis of Washington’s advice on credit and taxation:

1. Use credit as sparingly as possible.
2. Cultivate peace, but when absolutely necessary, it’s permissible to borrow to defend the nation.
3. Work vigorously during peace time to retire any debt that accumulated during war.
4. Don’t expect the next generation to pick up the tab.
5. It’s the responsibility of both elected representatives and the general public to reinforce these principles.
6. Taxes are always inconvenient and unpleasant, but the public should cooperate when raising additional revenue through higher taxes becomes temporarily necessary.

For you fact-checkers out there, here are President Washington’s own words regarding credit and taxation:

As a very important source of strength and security, cherish public credit. One method of preserving it is to use it as sparingly as possible, avoiding occasions of expense by cultivating peace, but remembering also that timely disbursements to prepare for danger frequently prevent much greater disbursements to repel it, avoiding likewise the accumulation of debt, not only by shunning occasions of expense, but by vigorous exertion in time of peace to discharge the debts which unavoidable wars may have occasioned, not ungenerously throwing upon posterity the burden which we ourselves ought to bear. The execution of these maxims belongs to your representatives, but it is necessary that public opinion should cooperate. To facilitate to them the performance of their duty, it is essential that you should practically bear in mind that towards the payment of debts there must be revenue; that to have revenue there must be taxes; that no taxes can be devised which are not more or less inconvenient and unpleasant; that the intrinsic embarrassment, inseparable from the selection of the proper objects (which is always a choice of difficulties), ought to be a decisive motive for a candid construction of the conduct of the government in making it, and for a spirit of acquiescence in the measures for obtaining revenue, which the public exigencies may at any time dictate.

In my next post I will quote President Washington on the need to maintain national unity.

The recent Employment and Housing data have not provided confirmation for the surge in bullish sentiment observed in December (unless you read the extreme sentiment as a contrarian indicator). The market exhibited a delayed reaction to another well-known technical indicator this summer, and I believe that’s happening again in this case. 

I first made note of the market’s unusual exuberance in July (Stock Indexes Ignore Technicians’ Head and Shoulders Calls). I found it odd that the market was enjoying a rally, despite the fact that stock prices had just completed a classic head and shoulders pattern. Of course, the predicted correction arrived in the fall, with a delay. Here’s one case in which the head and shoulders signal was profitable — there was plenty of time to make adjustments to portfolios or hedge the expected decline in equities.

I believe the case can be made that the same type of delayed reaction to the extremely bullish sentiment from December (a classic market top signal) is developing now. Just a few weeks after the surge in positive sentiment, we received unequivocally bad reports on variables that will be key in 2011-2012: housing and employment.  The recent dip in the Case-Shiller Index:

 and weak additions to Total Non-Farm Payrolls:

simply confirmed that analysts and pundits are, once again, too bullish. Moreover, when you also consider the trend in the Core CPI:

the recent numbers are more consistent with the Fed’s deflation scenario.

Why should the market exhibit a delayed reaction again, this time to the extreme optimistic sentiment from December? Asset prices reflect a premium for the Bernanke and other de facto put options that remain in-the-money, at least for now. These mechanisms encourage excessive risk-taking, which results in expected returns getting bid gradually lower. Just look at commodities prices. The market is running on animal spirits. Investors and traders are out of the habit of even looking at data — the market’s been shrugging off bad news for almost 2 years now (see Cullen Roche’s classic post from December 27, Equity Valuations are Stretched — But Does it Matter?). Combined with Goldman Sach’s trotting out Abby Joseph Cohen to shout “Synchronized Global Boom” in crowded theaters, the market’s had every possible signal of a short-term top thrown in its face — and valuations will most likely correct sometime in the next month or two, exhibiting the same delayed reaction as we saw following the July head and shoulders pattern.

Regarding the Fed’s ongoing involvement in markets, businesspeople and bankers who are in the trenches continue to acknowledge that these government mechanisms have been, and unfortunately continue to be, necessary to obtain the level of financial stability and confidence necessary for economic growth. And there’s no shortage of regional and community bankers who are still plenty nervous.

It’s a little scary to think that much of what we’ve accomplished thus far amounts to merely substituting 1.) government guarantees, 2.) a massive transfer of bad paper from private to public balance sheets, and 3.) ongoing zero real interest rates for the leverage infused into the financial system in the previous decade. The various guarantees and Quantitative Easing programs are merely leverage substitutes, only some fictitious future US taxpayer is on the hook for the whole thing. The US economy and financial system are not ready to take off the training wheels.

Put another way, the multi-decade experiment of coming off the gold standard has led to a grotesque endgame: The Federal Reserve desperately propping up asset prices and throwing everything it’s got at the problem of creating inflation (a task at which it has been completely unsuccessful thus far). I find it more than a bit macabre that we’ve all casually accepted that the best thing for long-term national prosperity is to debase our currency as quickly and completely as possible. Someone tell me again how that makes sense — I keep forgetting.

Yet another thing I regret having to write, but needs to be written nonetheless: The recent data suggest that we might not want to pull back on all those Federal Reserve pro-liquidity programs just yet. It’s not so much that I’m motivated to give the Fed credit for getting anything right, I just think in this case we have more of an accidental matching of the right medicine and the right time. I’d like to see the economic data firm up a bit more, preferably in a recognizable trend, before the Fed changes course.