Are Equity Markets Defying Gravity?

The Dow Jones Industrial Index, one of the key yardsticks for US equities hit milestone record highs last week!

Figure 1: Chartoftheday.com: Record High but needs a Hurdle to clear

Before we proceed further, one would most probably ask; of what significance is the Dow Jones to the Philippine counterpart, the Phisix?

Figure 2: stockcharts.com: Phisix-DJIA Close Correlation

The above picture tells you bluntly that the activities in the Phisix (red candle) have been closely correlated with the developments in the US markets, as represented by the DJIA (black line) for a lengthy timeframe. More pronounced is the almost lockstep movements of both benchmarks from May to the present.

Since the US markets have shown tight correlation with that of the Phisix, it is imperative for us to understand WHY their markets are behaving in such manner, its probable trajectory over the interim as to convey our risk-reward outlook, and importantly our possible tactical approach under the present setup.

Here is what Bloomberg reported during last October 4’s catalytic rise (emphasize mine), ``U.S. stocks rallied the most in seven weeks after the biggest part of the economy slowed and Federal Reserve Chairman Ben S. Bernanke acknowledged a housing slump, encouraging speculation that benchmark interest rates may decline next year...Service industries, accounting for about 90 percent of the economy, expanded in September at the slowest pace in more than three years and a gauge of inflation plunged. Bernanke said a housing slump will lop about a percentage point off economic growth in the second half and limit expansion next year.”

Here are the thoughts of some mainstream analysts in support of the Dow Jones’ landmark accomplishment (emphasize mine):

Dr. Ed Yardeni of Oak Associates, ``I figured stocks might rally strongly over the rest of the year because the Fed was done raising interest rates. Fed officials had accomplished both of their stated goals: (1) They succeeded in taking the "froth" out of housing.... (2) They are succeeding in containing inflation.

Mr. Tobin Smith of Changewave.com, ``Earnings per share at the S&P 500 companies (which represent 87% of the $15 trillion U.S. market cap) are NOT growing at 14% on the operation level. They are at the earnings per share (EPS) level because of stock buybacks. As my ol' buddy Bob Olstein of the Olstein Investment Funds always says, "Growing EPS via stock buybacks is JUST as real as growing EPS from operations." A 14% EPS for S&P growth in a 2.5% growing economy is breathtaking, and it makes the S&P 500 at 13 forward P/E cheap.

``Prices at the gas pump really do have a oversized impact on consumer sentiment... Oil is 25% down from the highs, and $55 to $65 oil is the new, new trading range...There is a GIGANTIC liquidation and redemption sale going on in the energy patch.”

``There is a LOT of money coming back to the good 'ol market from the day traders of the residential housing market -- i.e., the flippers...The next Fed move will be DOWN, not up...A lot of people have missed this rally -- and they want in.”

Let us summarize the latent missives we are getting from the recent rally.

1. A slowdown is good for the market because interest rates WILL go down.

2. Lower Energy Prices are helping CONTAIN INFLATION.

3. Stock buybacks are DRIVING earnings.

4. Money from Housing and Energy or those from the sidelines will SHIFT to Equities.

And all the while you have been made to believe by investing textbooks that stock market investing was about earnings growth, right? Well how does one expect higher earnings or rising dividends on an economic slowdown or a general downturn in the business cycle? This simply defies logical arguments and it certainly beats me.

Lower interest rates or lower price of money would be permissive for investors and speculators to increase on leveraging or borrowing more which in essence translates to MORE inflation! Stock buybacks generally help investors in terms of levitating share prices or keeping share prices afloat but does not increase future cash flows by expanding underlying corporate operations or improve the economy’s capital stock. On the other hand, sectoral rotation simply implies momentum investing where money managers go for “popular themes” in pursuit of short term returns at the expense of disfavored ones.

So based on the above premises, the conventional thoughts on stock market investing have been apparently displaced by “inflation expectations” or the speculative impulses borne out of the inflationary bias deeply embedded in the present global financial system. As I’ve noted in numerous occasions today’s financial markets are driven by rampant speculation arising from too much money and credit creation and intermediation.

Now as to the argument that lower energy prices help contain inflation is grounded on an equally flawed premise. Dr. Frank Shostak of MAN Financials, in his very insightful contributory article to the Mises Institute, “Will An Oil Price Fall Push Inflation Down?” explains why (emphasis mine)...

``If the stock of money rises while all other things remain intact, this must lead to more money being spent on the unchanged stock of goods — which means an increase in the average price of goods. (The term "average" is used here in conceptual form. We are well aware that such average cannot be computed).

``If the price of oil goes up and if people continue to use the same amount of oil as before, people are now forced to allocate more money for oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down.

``Note that the overall money spent on goods doesn't change; only the composition of spending has altered here, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged. Likewise, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.

``In other words, it is not possible for rises in the price of oil to set in motion a general increase in the prices of goods and services without the corresponding support from money supply.”

``One could, however, argue that a rise in the price of oil may cause the Fed to increase its monetary inflation and this in turn should provide the support for a general rise in prices — all due to the increase in the price of oil. Even if this were the case, it would have almost no effect on the growth momentum of the CPI. The time lag is simply too long. Present price inflation is driven by past monetary injections.”

In short, it is the amount of money in the financial system that determines inflation and not the price of oil. Talks of lower oil prices as an impetus for lower inflation are merely claptraps employed by analysts in order to justify their opportunistic biases. Put differently, like typical mainstream analysts, they make truth the way the want them to be.