A Thought Experiment
Jack McHugh engages us in this delightful thought experiment:
>
"Let's try a little thought experiment to examine just how well stock prices reflect what's happened this year.
Imagine it is January 1, 2007, and you have just been given the following information about what would unfold during the first 8 months of the year:
-- Oil prices would rally back to over $75/bbl;
-- The dollar would drop against every major currency;
-- Corporate earnings would benefit from the greenback's slide and continue to post double digit gains;
-- The housing industry, instead of bottoming, would continue to slide all year;
-- Home prices would actually be down in many major cities;
-- Over 90 mortgage lenders would cease operating and the survivors would be on life support;
-- The origination of subprime mortgages would all but cease;
-- All but prime, conforming mortgage loans would be either hard to get or very pricey;
-- Private equity deals would soar in the first half, but come to a halt after July 1;
-- Some prominent LBO deals would have to be "eaten" by commercial and investment banks;
-- The leveraged loan market would see stress;
-- High yield bond spreads would widen markedly;
-- Commercial paper would come into question and ABCP conduits would be in jeopardy;
-- T-Bill yields would plummet into the 2% area before rebounding to fed funds minus 85 bps;
-- LIBOR would actually rise from +10 bps to fed funds to +45 bps to fed funds;
-- Loans for all second tier credits would either be very costly or unavailable;
-- Prominent hedge funds would either blow up, face losses, or have investors seek redemptions;
-- Volatility, as measured by the VIX, would triple from 12 to 37, before settling in the mid 20's;
Given the above information, where would you expect the major stock averages to be in relation to their closes on December 31, 2006? Ah, you need more information about how the authorities responded, right? Well...
-- The fed funds rate would still be at 5.25%, but the discount rate would be down 50 bps
-- Regulators would be seeking ways to allow delinquent borrowers to remain in their homes
Now, given this admittedly limited information about market moving events and governmental responses to them, where would stock prices be? Down 10%, 20%, perhaps?
The answers are:
* The Dow is up just about 8% for the year
* The S&P is up just about 6% for the year
* The NASDAQ is up just shy of 10% for the year
If you are surprised, you are probably not alone.
As to whether stock prices have fully factored in the withdrawal of credit described above, it may depend upon whether or not the promises made by Chairman Bernanke and President Bush ever come to fruition (and how quickly).
Judging just by the price action to date, however, it seems Mr. Market has decided there is little or no chance that either the markets or the economy experience anything but peace and tranquility for the rest of the year.
Then again, the old gentleman didn't see all the housing troubles coming in the first place. How can we be sure he so clearly sees the proper solution(s) will be applied in the future?"
>
Great stuff. Thanks, Jack.
Wednesday, September 05, 2007 | 11:30 AM | Permalink
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Mr. Market has been, for some time now, asleep at the wheel.
Posted by: Mike M | Sep 5, 2007 11:38:08 AM
peace and tranquility today, tomorrow, in fact for all time.... unless of course a Democrat were elected President. then, a depression.
Posted by: scorpio | Sep 5, 2007 11:42:10 AM
Heads are definitely in the sand. It's not that unusual though. I remember the prime rate had to drop from nearly 20% to 14% before the bull market in 1982 finally got going. This situation seems to be the reverse, but over an even longer timespan. There seems to be a huge under-estimation of the effect of the credit crunch on the housing situation. The loss of all of the marginal demand from the sub-prime borrowers is going to have a large impact on home prices. The domino effects will be felt world-wide.
Posted by: Stockmarketadvantage | Sep 5, 2007 11:53:14 AM
You forgot to add the one MAJOR factor that is the SOLE reason for where the market is today:
CHINA
That is why we are up when most indicators have pointed (and have been pointing) down.
Simplistic?? yes
Please make me wrong...however that is the only rationale explanation( that I can come up with) as to why we are still less than 4% from the all time high and our credit system has imploded.
Think Olympics and then election (although I really think that once the olympics are over...it's really over since the chinese have less and less motivation to prop up our market.
Can't have any analysis without the China factor.....
Ciao
MS
Posted by: michael schumacher | Sep 5, 2007 11:53:39 AM
Alan Greenspan found the answer over a decade ago:
I think it was inexplicable exuberance or something similar.
Posted by: Werner Merthens | Sep 5, 2007 12:10:52 PM
I see that no 'good' stuff is listed, so the list is really meaningless, isn't it?
Posted by: wally | Sep 5, 2007 12:19:23 PM
why don't you come up with a list wally...
I'm sure you can find things out there to counter the reality of it all.......LOL
Ciao
MS
Posted by: michael schumacher | Sep 5, 2007 12:21:39 PM
China 2007 = Japan 1989, but maybe even worse given the utter destruction of their environment.
Posted by: skateman | Sep 5, 2007 12:24:33 PM
China is a linchpin of the argument: US capitalism has outsourced its cost structure and taken a huge chunk out of the middle in the form of CEO income and extra-normal profits to shareholders.
Posted by: scorpio | Sep 5, 2007 12:35:50 PM
since wally brought it up, let me list the good stuff:
1. upto $2 Trln can be deployed to prop the market/economy, every central banker in the world is in favor of a bull market (they dont want painful correction, but they dont mind inflation)
2. china/india/brazil or other exporting countries do not want usa to go into recession, it will be more painful for them since they are still barely able to get bread to the table.
3. most countries including Europe do not want the dollar to fall more, since thats making their exports expensive relatively. Since usa does not export much and everyone else do a lot of export.
4. All the funds currently invested in stocks do not want to sell(to lower price to reflect the risk) because its mostly not their money (401k, mutual fund etc) and most investors who have put money into the market are like gamb-lers....the dont care about a 2-3% loss they think they can time the market and exit before it goes down 10-15%.
5. i am getting into the belief that we may get rate cuts to prop the economy because no one other than oil producing countries are going to be bothered by falling dollar (most of them have pegged their currency to stop bleeding from export loss)
6. There is a possibility that the data we have about consumer debt is not accurate, i have read that the DSR is just around 15%, which does not sound correct, so if it is right then consumer still has 85% of disposable income to support consumption.
This is the biggest question of the hour: where does the consumer stand right now?
7. Job market is still pretty good, if not for the credit market freeze hiring/expansion may have kept going on.
its quite possible that business will reduced capex expecting a downturn, consumer may reduce consumption due to negative sentiment and high debt servicing cost.
i still prefer to stay 90% in cash, no shorts and just 10% in mutual funds.
Posted by: techy2468 | Sep 5, 2007 12:43:35 PM
"If you are surprised, you are probably not alone."
Exactly! The market will spank the most people it can. There has been an abundance of negativity, and bets made against the market. The "crowd" is confused? Shocker.
Yes MS, BRIC is a major influence in the global growth story. Billions of new consumers are buying stuff, and getting paychecks.
They say it's not the news you should watch, but the reaction to it -- that counts.
Posted by: Fred | Sep 5, 2007 12:45:13 PM
"Markets can stay irrational longer than you can stay solvent." Keynes
Posted by: Owner Earnings | Sep 5, 2007 12:47:04 PM
Fred.
it would be so nice if the bulls started using reasoning and data to support their argument instead of plain rhetoric.
why not you start a list of positive things supporting the current markets?
Posted by: techy2468 | Sep 5, 2007 1:00:17 PM
techy2468 points out ...
'2. china/india/brazil or other exporting countries do not want usa to go into recession, it will be more painful for them since they are still barely able to get bread to the table.' endquote
so then when USA does downturn they will finally be able to supply themselves with their time, energy and product
there is your play marketeers - raw commodities and uncopyable machine repair parts
Posted by: Greg0658 | Sep 5, 2007 1:03:19 PM
techy-
Fred can't or won't do that......
I expect to hear (yet again!!) that CAPEX will save us, China's consumers will save us (oh wait he's already said that), and tech will save us. and a rate cut will save us as well.
Yes PLEASE come up with a list that counters what was put up today........going to be the shortest list you ever see.
What most perma bulls fail to admit is the massive bullshit (ala these 300 point rallies) that come from nowhere are all the product of a system that is steadfastly in a state that is so far from reality they continue to just see it continuing for no other reason because...well it can.
China=MM
Was it a coincidence that Goldman Sachs bought over 1000 SP contracts on that thursday (before the fed cut the discount rate) at the low of the day?? How do you spell manipulation?? CHINA and Goldman.
How many trips did Paulsen make already this year?
Ciao
MS
Posted by: michael schumacher | Sep 5, 2007 1:13:33 PM
"3. most countries including Europe do not want the dollar to fall more, since thats making their exports expensive relatively. Since usa does not export much and everyone else do a lot of export."
Except the US is the world's largest exporter and 2nd to Germany when only including durable goods. The weak dollar should have closed the trade deficits and increased foreign travel into the US. Instead the Chinese currency is artificially priced and few Europeans want to vacation in the US due to world affairs.
Posted by: Brian | Sep 5, 2007 1:17:13 PM
Brian - 'Except the US is the world's largest exporter' endquote
Can a originator/middleman ratio be put to that statement?
Posted by: Greg0658 | Sep 5, 2007 1:26:52 PM
Guess it all depends on whether the market is a discounting mechanism or a mechanism for policy transmission.
Posted by: Les | Sep 5, 2007 1:30:57 PM
In today's world, where ever the powers that be want it. The notion of a business cycle has been replaced with continuous asset bubbles. If this were the late 1970's and early 1980's, we would be in a much different place, but that was before a never ending Bull Market was needed to prop up the economy and the ridiculous asset prices we see today.
Can you imagine for one minute that Paul Volcker would have played candy man to the markets the way Greenspam did for 20 years?
Posted by: SPECTRE of Deflation | Sep 5, 2007 1:37:32 PM
The US is a significant exporter and the trade imbalance numbers have been closing as of late due to increased exports. If you want to consider the US economy, you pretty much have to throw out the DOW and one is tempted to throw out the S&P 500. There is simply too much noise in the data. For example, everyone wants to talk about Ford's domestic losses, but near 50% of their revenues are from overseas. They are growing marketshare in Brazil and Russia for example. That doesn't matter to the assemblyman in Dearborn though. As to what we do export, you have software, airplanes, medical equipment, and a myriad of other things. This is why I would hold off on the apocolypse expectations.
As for the view that there is a wide well of support for the dollar, show me the evidence over the prior 5 years of this. Even if we posit that there has been currency manipulation, which is entirely reasonable to posit, this just establishes that support is being eroded. The OPEC states are already moving heavily into the Euro. Russia has made clear that its position on the dollar is based on what is in its best interests, and Russia doesn't have vibrant trade with the US. Their trade is primarily with Europe, and they are putting heavy pressure on Europe to reign in their inflation so that Russia can reign in its inflation. This is why you will continue to see divergence between the dollar and the euro.
Posted by: M.Z. Forrest | Sep 5, 2007 1:39:18 PM
Its called the Efficient Frontier, and near-perfectly diversified portfolios (like the ones noted) lie on this frontier. Most diversifiable risk is diversified away, so unexpected events confirned to one or two segments have minimal effect on price.
Posted by: atlas | Sep 5, 2007 1:48:33 PM
http://tinyurl.com/2pytnu
The link is from the German Embassy in London. We still export a massive amount of agricultural and military goods, along with intellectual property, even if we don't make easy-bake ovens any more.
Posted by: Brian | Sep 5, 2007 1:49:42 PM
the "easy bake oven" has morphed into the "easy credit implosion" that is contained.
Two more casualties of the contained containment:
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZkz_UtSTkP8&refer=home
Who's betting on yet another rescue of the market by the fed release in a few minutes??
I am...too neat
Ciao
MS
Posted by: michael schumacher | Sep 5, 2007 2:00:52 PM
"I see that no 'good' stuff is listed, so the list is really meaningless, isn't it?"
There was one good thing on the list, namely:
-- Corporate earnings would benefit from the greenback's slide and continue to post double digit gains;
And this is no small "good thing." If earnings continue to grow all is well. The market will not see the negative until it can see the negatives impacting the companies in the market and right now, it sees companies continuing to produce as if there are no negatives so why should the market care.
Sooner or later this has to hit the companies that make up the market or else it just won't matter.
Posted by: Red Ocean | Sep 5, 2007 2:00:55 PM
watch the SPY at the LOD......China will show up before the end of the day....
Ciao
MS
Posted by: michael schumacher | Sep 5, 2007 2:06:58 PM
