This note was originally published June 01, 2011 at 08:24
“It means no worries,
For the rest of your days,
It's our problem-free philosophy,
-The Lion King
Hakuna matata is a Swahilli phrase that means, literally, there are no worries. The term was first popularized by 1980s rock band, Boney M, but gained most of its popularity in the 1994 Disney animated hit, Lion King. Yesterday, the U.S. equity markets closed solidly to the positive with the benchmark SP500 closing at 1,345 near the highs for the day. Hakuna matata! Right?
Certainly, yesterday’s stock market action reflected a care free / hakuna matata type of attitude, especially given the backdrop of the economic news of the day. There were actually three data points out that caused your grumpy old risk managers at Hedgeye a little concern. They were as follows:
1) Chicago PMI - The ISM’s Chicago business barometer dropped from 67.6 in April to 56.6 in May, which was its lowest reading since November 2009. This was the largest one-month deceleration since October 2008. Clearly ominous, although perhaps somewhat attributable to the region’s exposure to the auto industry and shortage of auto components from Japan (at least, that’s the spin). The comments from the recipients of the survey were fascinating and can be found here: https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-CMay2011.pdf
The common themes were price inflation and slowing growth.
2) Case-Shiller Index – According to the Case-Shiller Index, U.S. home prices fell for the 8th straight month and were down 4.2% for Q1 2011 versus Q4 2010. This is an accelerated decline versus Q4 2010, a quarter in which home prices fell 3.6% quarter-over-quarter. Declining home prices are negative for the financial sector, as banks have to adjust residential mortgage loan books accordingly, and negative for the outlook for consumer spending, especially on the low end. According to the Case-Shiller report, home prices have now fallen as much as they did during the Great Depression. In that period, it took 19 years for the prior peak to be revisited.
3) Consumer Confidence Index – The Conference Board’s index of consumer confidence dropped 5.2 points in May and is now at its lowest level since November. The Hedgeye Optimism Spread continues to contract, as the expectations component led the decline falling to 75.2 from 83.2 (previously 82.6). The present situation component dipped to 39.3 from 40.2 (previously 39.6). Overall, the assessments of future business and labor market conditions fell in May.
As we noted at the outset of the note, the equity markets completely shrugged off the economic data points above and closed at, or near, the Hakuna Matata Highs of the Day. Now to be balanced, these data points are mostly backward looking, except for perhaps the consumer confidence reading, so it is, maybe, understandable that the market looked through the news.
That said, speculating on the meaning of market price moves is just that - speculation. To reduce speculation, we incorporate a quantitative process around looking at market prices. As Keith and I learned in our early days in the hedge fund industry, markets or stocks going up on bad news is an important signal, but it does need to be confirmed. That is, one day a trend does not make. As well, short term price action needs to be placed into the greater context of market sentiment and psychology.
To the last point, we have posted in the chart below a look at NYSE margin debt versus the SP500 going back to January 1997. The takeaway from this analysis is that when margin debt has reached an extreme of 1.5 standard deviations above the mean, the SP500 has seen a 50% correction in the ensuing 18 months. We are certainly not calling for a crash or correction to that degree, but wanted to highlight this context, which is simply that stock market operators are leaning levered long - in a large way.
Over the course of the past couple of quarters, there is no doubt most stock market operators have experienced some level of cognitive dissonance. Yesterday’s action likely accelerated those experiences. On the positive side of the ledger yesterday, a Greek default seems to have been punted, which is positive on some level for some time frame, and the economic data suggested, to our Q2 Theme, that The Bernank has continued clearance to stay Indefinitely Dovish. Therefore, if fixed income earns you little, or at least historically low rates of return, then perhaps equities are marginally more appealing? Thus the equity markets reacted accordingly yesterday . . .
We certainly understand this line of reasoning, but remain concerned that the “valuation” case for the U.S. stock market may not be what it is cut out to be. As inflation accelerates and growth slows, corporate margins contract, and earnings growth becomes challenging. Recall that at the end of 2007, the SP500 was trading at 17.3x forward earnings of $84.67 per share, except for the fact that the real earnings number was actually $60.57, or 28% lower than expected. There was little cognitive dissonance by the end of 2008.
Keep your head up and stick on the ice,
Daryl G. Jones