Are Stocks Pricing OUT Duration of Slowdown?

Posted by urbandigs

Wed Apr 29th, 2009 01:28 PM

A: Shorts are getting absolutely murdered on this latest rally, right at the same time bad news is being reacted to positively, and complacency slowly seeps in; the VIX is near 35 now and falling. This is not a normal stock market folks because we are bouncing from an unprecedented cliff dive, so don't interpret the euphoria that comes with a sharp bear rally to mean that any form of a V shaped recovery is at hand. That is the concern here. As stock prices rise, expectations rise with it that future growth prospects are brighter. The higher the stock price goes (forget for a moment what other forces are powering the move), the less of a value it becomes on a P/E basis - makes sense right; if AAPL stock rises from $78 to $125, would you say the stock is cheap right now after a 47% move? Depends on the future growth prospects and earnings. In my opinion, stocks are PRICING OUT THE DURATION ELEMENT of this slowdown - and that may come to hurt us later on as expectations are changed. Its the duration of this slowdown that I think will disappoint the stock market down the road.

There are real reasons why this market is rallying considering the cliff dive we came from: credit is much tighter, new home sales surged, pace of decline seems to be slowing, banks handling stress test and dilutive news positively, etc.. Its NOT the severity re-pricing that I think is wrong, rather, its the pricing out of the expected DURATION of this crisis that I think will prove wrong here.

The bottom callers on CNBC are getting their 3rd, 4th, and 5th chances to call a bottom since the equity decline began in the 4th quarter of 2007. Keep on calling it, and eventually you will be proven right. Only Mark Haines had the cahones to actually come out and call his first bottom on March 10th, with the Dow trading at 6,926. Everyone else waits for the markets to bounce 10-15% and then they say the bottom is in for fear of calling it on or near the lows.

Here are some recent news breakers and how I feel the street is interpreting it (envision a V-shaped recovery):

Citi/BAC CDS Widen on Report More Capital Needed --> No problem, its priced in. As long as this is the last round of capital raising and the government will not allow either to fail which would see common wiped out, and haircut to preferred and bondholders - no problemo!

GDP Contracts 6.1%, Worse Than Estimates --> No problem, its priced in. As long as pace of decline is slowing, inventories are being taken down, and consumers are starting to spend again, its a clear sign that the worst is behind us and future growth may in fact lie ahead. Besides, if it we don't grow that much, we can always get our government to give us another stimulus package. Consumers obviously can and will keep on spending, and that is a very good thing with no possible side effects. They will only spend more as things improve.

Bank Stress Tests Reveal 6 of 19 Banks Need More Capital --> No problem, its priced in. As long as ONLY 6 banks need capital, and this is the last feeding from the trough! The good thing is, this should be the last round of capital raising. After this, its full gears ahead! So what if rates may rise down the road and consumer credit quality is deteriorating, that won't stop us banks from churning out loans!

Commercial Crunch May Reach $1 Trillion --> No problem, its priced in. As long as it is ONLY $1Trillion, what is a few trillion amongst friends anyway!

Just to name a few. We must ask ourselves whether or not an environment of rising unemployment and deteriorating home/commercial prices will allow for a bottom in bank losses and a sustainable rise in consumer spending?

With each rally, more complacency sets in and more shorts get murdered. Shorts start out by shorting more, dollar cost averaging their positions, until they cant take it anymore and liquidate the position adding fuel to the buy side pressure. Before you know it the momentum and program trades get crowded, and forces outside of normal fundamentals start controlling the stocks markets. People scratch their heads wondering if equities have it right or wrong, hedge funds scramble to make sure they don't miss the run, and retail investors get sucked in with the hope that the economy is finally turning with growth on the horizon. Confidence is magically restored and the world is all better again only 2 months after everybody thought the world was ending! But is the world all better again? Is debt service down? Are bank balance sheets cleansed and fully capitalized?

I fear that stocks are in the process of pricing OUT the duration element of this recession - and moves are powered more by short term trading forces. What I mean is, they got the severity of the recession right by taking stocks down 57%-60% or so from peak over the course of 16 months. But now that we have rallied 30% from those lows, I fear that stocks are in the process of pricing OUT the duration of this slowdown, and instead are beginning to trade as if future growth prospects are assured. As the rally continues this sentiment grows, and so does euphoria with it - the trade is perceived as being crowded and less and less of a value discounting future growth potential - unless the growth really is there! The stock market is a discounting mechanism, nothing more, and is not always right!

Equities discounting vision was very wrong in late 2007, when credit was telling a much bleaker story, and stocks were wrong again in May 2008, when the Bear Stearns 'elimination of systemic risk' rally assured investors that the fed can & will always save the day. So, don't interpret stock rallies to mean that all is well again when they got things wrong big time twice in the last 18 months alone. I see Mish & BR talking about technical indicators of an overbought rally, but to me, it just feels like the market NEEDS to go higher right now because of the trading forces at play right now - quants, shorts, momentum traders, hedge funds getting in on the move, etc..

But did the fundamentals all of a sudden get better? Are consumer debts cleared out? Are banks all better again? And what about side effects of policy down the road? Ignoring the possible unintended consequences of policy actions taken to stem this crisis, is to believe that there are always free lunches to the tune of trillions of dollars with no side effects. The fed has seriously compromised its balance sheet by taking on riskier assets via short term credit facilities and is on a mission of printing money to buy agency MBS and treasuries right when demand might slow from private sector; the last option at their disposal to expand the money supply and keep rates as low as possible. Who knows what Pandora's box that may open later on.

In the meantime, stocks seem to be pricing in a bottom with the worst behind us - with short term and program trades ruling the field. Perhaps on the severity front, stocks may be right - the worst may be behind us. But is growth, and more importantly, sustainable growth really on the horizon? What happens to banks when good assets start turning bad? What happens when off balance sheet toxic assets and accounting tricks no longer can hide damage? What happens when fed credit facilities are removed, rates are raised, and treasury yields start to rise? How do higher borrowing costs and higher taxes as a side effect from all these steroids, affect businesses/consumers trying to increase profits and decrease debt service? State budget concerns? All those unemployed? This is why I think stocks pricing out duration are wrong!

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