More on “A Tale of Two Markets”
Last week we presented our view on the current market environment in our post, A Tale of Two Markets: M&A, IPOs to reignite animal spirits:
We are currently experiencing a time when fundamental US growth is anemic (at best) and true financial and technological innovation (which drives real growth) are absent.
Policies in Washington and Wall Street have realized that they have but one last weapon in their monetary arsenal and that is to take the markets higher, in what has become known as the Fed’s ‘third mandate’. Quantitative easing has succeeded thus far, lifting the markets +91% from March 2009. Now that fiscal deficits and the Fed’s balance sheet have ballooned to record levels and have become a politically sensitive topic, Washington and Wall Street will have to look to another alternative to fulfill their new mandate.
The Market Innovation that will prop markets higher will focus on earnings from blue chip companies and those comprised within the S&P 500 at the expense of the rest of the asset classes. And since earnings growth will not occur organically, the catalyst will come from a resurgence in M&A and IPO activity. Cash-rich companies will undertake accretive acquisitions and do their part in lifting earnings and the indices while the big players (banks, brokerages, hedge funds, etc.) will rally IPOs in a dual attempt to suck in the sidelined retail investor, reigniting those animal spirits that are indispensable to the vitality of the game. Knowing how paramount the markets are to the psychology of the economy and its ability to ‘create wealth’ (or at least the illusion), Washington and Wall Street have but no other option. This period will come to be known as the tale of two markets.
We explained this ‘outside-of-the-box’ thinking as “the most honest way to revive a moribund market short of a true innovation.” Lest we be outdone only days later by the Treasury Borrowing Advisory Committee’s latest minutes, which offered a new take on financial innovation proposing to offer 40yr, 50yr, and 100yr and GDP-linked bonds to an array of investors in order to meet the new $2.4 trillion demand (see article). What once was a farce is now a grim reality that we must deal with. The growth-obsessed system is bleeding for sources of innovation at all costs and it seems to be getting overtly desperate.
That is why we still believe this latest market innovation will most likely succeed in resurrecting those necessary animal spirits, creating artificial wealth; QE3 more likely deployed (Look at friday’s 30-yr at 4.72%); and economic data misstated (Friday’s ADP). But the tale of two markets continues to play on.
On a fundamental level, we tend to agree with investment managers like David Rosenberg. We even stated weeks back the greater chance of a 10% correction based on higher commodity prices and the lack of fundamental growth in the economy. We agree we cannot have real recovery until unemployment (actually 12.8%) comes down considerably, housing prices stabilize (said to fall another 10-20%), and consumer demand returns to normal levels. None of the three show signs of turning around anytime soon. But we are no longer living in rational, fundamentals-based times in the market. And even Mr. Market himself, Warren Buffet, conceded that the markets have become nothing more than a casino.
So, Market Innovation in the meantime will have to come through. And who knows at what cost (again look at the 30-yr). Niall Ferguson had stated last week that QE2 went overboard and then there was Bill Gross’ harangue, a threat for the bond vigilantes to take action. Both believe in the likelihood of what I call “Black Swan Bets”, and higher yields could pose a serious problem down the road.
And we agree with David’s ‘day of reckoning’, but not for at least another 24-36 months. In that time the markets have plenty of support in the Fed and excess fuel in sidelined investors to take the markets higher. And just as there is a chance, an instantaneous moment, in which the markets topple over on say a bond vigilante raid, there is a greater chance that a similar moment which sees markets creeping higher could finally reignite the unbridled animal spirits and break the sidelined investor levees, bearing witness to an equities deluge like no other.
The Day of Reckoning is coming, just later rather than sooner.