When I was a kid (I still am for that matter), I remember going from door to door in mother-made Halloween costumes with my two older brothers and my friends around our University of Kansas neighborhood. The door would open and with bright smiles, in unison, we would firmly announce “trick or treat” to the door bearer who would eventually let us dig into the large basket of assorted candy.
We would go on our merry way to the next bright porch light. At the end of the night we would see who the big winner was or the one with the most candy. Undoubtedly, this would be one of my older brothers as they would reach into my bag for an extra handful as we returned home. However, we would sift through the good and the bad candy before indulging ourselves with tootsie rolls, butterfingers and snickers into a fidgety sleepless night of sugar sickness. Most everyone has similar childhood memories of Halloween, but you may be asking why I would begin to tell this story in an investor newsletter. Somewhat because I like to tell interesting stories, but more importantly I talk about it to heed warning to traders who may be acting as kids on Halloween night; greedy, happy and complacent humans looking for more.
Let me describe the scenario a little more. Each time we go to a new door, we came asking for more and more candy always looking to collect as much candy as we could even though we knew we already had enough and didn’t necessarily need to overload our candy bags. We were kids; irrational, illogical, greedy kids who always wanted more because we thought we deserved it or needed it. I believe the markets and traders for that matter are setting up the same storyline.
Traders and investors are being greedy and irrational in a market that has continued to fill up on good news (Snickers) in a market filled with both good news and bad news (representing the good and bad candy). The market has sifted through the good and the bad news and focused solely on the good (who wouldn’t want to eat all the Snickers before having to eat the stale candy corn). At some point we indulge ourselves into a fidgety sleep thinking that the market has rallied on the back of all the good news (Snickers) only to see that below the surface (in our stomachs) too much news (sugar from the candy) has expanded the markets beyond their ability to sustain (bulging our stomachs into a fitful sleep). We overlook the bad news because the taste of the good news is just so good that we can’t get enough and eventually fall sick and come back down to earth, learning a lesson or two along the way as equities (and our bulging stomachs) return to normal levels.
The Dow, S&P 500 and Nasdaq are up 13.7%, 12.5% and 17.0% respectively since the lows of mid-July. That may not seem like much, but in 3 months it is a large enough move without a solid correction to worry about. Markets can stay overbought for irrationally long periods, but generally after these long overbought periods the market is trailed by a large correction. Although we don’t time the market, I feel as if the market is close to filling up on Snickers and Butterfingers and may finally feel sleepy and tired before falling into a lull or mild correction. Why?
There is too much data to truly analyze in such a short article, but I would like to take a look at a few things; inflation, economic growth and earnings. All of these have a large effect on the overall market, but do not individually define its performance.
As evident by the earnings being reported in the S&P 500, companies continue to defy estimates. S&P 500 companies’ 2nd quarter earnings estimates were 8% before reporting a 13% growth. 3rd quarter earnings estimates were then raised to about 13% because the outlook looked solid. According to www.briefing.com, about 1/2 of the companies have reported and have consequently raised their estimates to 18%, which is fitting since this will be the 18th consecutive double digit earnings growth for S&P 500 companies. That’s an impressive run that dates back to mid-2002 when the markets started to bottom out (even though we wouldn’t know it was the bottom until 2003). So that means the economy is growing, right?
The U.S. economy continues to expand and grow through a period of time that the Federal Reserve, and just about everyone else, thought the economy would see even more signs of deceleration. Some of these concerns were due to high oil prices and higher interest rates eating into consumer spending. Since these initial forecasts, oil prices have dropped more than 25% and consumers have increased their spending (consumer spending accounts for approximately 2/3 of the U.S. GDP). Remember, this was during a quarter that was expected to see slowing growth. As you can see by the chart below, GDP growth has been in a solid growth period since the 1st quarter of 2002. Interestingly enough, 18 straight quarters of double digit growth has coincided with the economic expansion since the middle of 2002. Although economists are predicting the GDP growth to slow this quarter and next, it is evident that the upward growth trend is still in tact and it may be a few more quarters of moderate growth before we see some real signs of slowing.
Everyone knows Ben Bernanke and Co. (Federal Reserve) have been eyeing inflation because if it persists at current levels, they could hike interest rates once again (not expected, but possible). If the economy continues to grow in line with the current trend, which will be driven by consumer spending and the housing market, inflation could end up being a detrimental problem to the “Goldilocks Economy” scenario. By looking at the second chart below, you can see that the Consumer Price Index (CPI) excluding food and energy (which is what the Fed watches for tolerable levels) has been trending up as well. If this persists, which it may not, we may want to be aware that the market has priced in a “Goldilocks Economy” and could be ripe for a fall at any point.
I understand that this story may seem outlandish, but I have been trying to rationalize the markets latest move higher. Undoubtedly, no one will ever get it down to a perfect science, but it is a funny world out there and rationalizations can come from charts, psychological movements and even childhood memories that drove our actions. I hope you enjoyed the storied analysis.
Source: Briefing.com, PTP
Charlie Santaularia
Managing Director
Parrot Trading Partners, LLC
www.parrottrading.com