Are Markets Always a Discounting Mechanism ?
On Kudlow & Company last night, Doug Kass and Larry got into a debate (with Art Laffer refereeing) as to whether markets are a true and reliable discounting mechanism.
Kass' position was that they are often not. I am found of saying the market was as wrong at Nasdaq 5000 in March 2000 -- earnings didn't matter, its a new paradigm -- as it was with Nasdaq at 1100 in October 2002, when profitable debt free companies were selling ofr les sthan book value, and in some instances, less than cash on hand.
Shedding some light on this is David A. Rosenberg, Merrill Lynch's North American Economist. Rosenberg looked at whether a recession could begin with equities at or near all time highs.
The answer, surprisingly enough, is yes:
"The S&P 500 peaked on July 16, 1990 after a 3.4% burst over the prior month and the recession began that very same month. Go back to February 13, 1980 and you will see that the market peaked and came off a huge 7.8% melt-up in the previous month – and the recession had begun the month before. . .
What we do know is that the economic backdrop has become worse, not better. Over 90% of the economic data have come in below expectations in the past month and our internal Data Diffusion Index has hit its low-water mark for the year . . . "
Stock markets are not always perfect discounting mechanisms:
Source: Merrill Lynch, Standard & Poors
As Jack McHugh points out, many investors seems to think a recession would either be bullish (because the Fed would continue to ease) or would be an impossibility (because the stock market, "discounting mechanism" that it's supposed to be, is hitting new highs). And he notes that markets also peaked in 1929, even though the highs were seen a couple of months before the onset of the Great Depression.
McHugh:
"I suppose it's possible that the price-worshiping, momentum crowd has it right and that nirvana lies just over the horizon. Given the worsening problems in housing and mortgage finance, however, it's possible, just maybe, that the quantitative model-builders in equity land will prove to possess no more genius than their fixed income cousins displayed when constructing subprime CDOs."
Discounting mechanism, indeed.
Wednesday, October 03, 2007 | 10:18 AM | Permalink
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Tracked on Oct 10, 2007 10:20:32 AM
Comments
I was reading Devil Take the Hindmost a few months back and the author points out that traders in 1929 kept pushing prices higher not based on what companies were doing now, but what people believed they would do in the future. Then I happened upon an article yesterday by Jack Schoen observing that traders currently are trading not based on current economic conditions but on what they believe will happen in the future, say a year from now. Funny, that.
Here's Schoen's article if you're interested:
http://www.msnbc.msn.com/id/21086790/
Posted by: Florida | Oct 3, 2007 10:51:27 AM
Now your talking! This thing is getting very close to going bing, boom, bong! The ISM, "sounding" mixed to slightly hinting, that a big rock lays ahead. My guess is that it's Gibraltar.
Posted by: Justin | Oct 3, 2007 11:06:58 AM
Obviously stocks benefit tremendously if the US can continuously devalue the dollar without having interest rates go up.
Posted by: Fullcarry | Oct 3, 2007 11:09:07 AM
Florida,
Isn't that the current theme driving equities. Bad news being ignored cause the Fed is easing to avert a crisis and the liquidity ends up in equities and creates a bubble somewhere. But traders will be able to get out before the economy really stalls out. If we are following the 1998 model then we have a 1999 in front of us.Lots of time to get off the train.
I'm not sure I but it though. the trade is crowded plus Micron's reaction and news today proves we are in a different scenario.
Posted by: Kman | Oct 3, 2007 11:12:06 AM
"traders in 1929 kept pushing prices higher not based on what companies were doing now, but what people believed they would do in the future."
Also known as the "bigger fool" theory in financial terms.
Posted by: me | Oct 3, 2007 11:13:38 AM
Obviously you have to differentiate between long term and short term. Short term 'the market' is more like a mob, shoving back and forth, driven by some thing or other. Longer term and on average its a discounting mechanism. If more one looks at "the market" in aggregate, than one stock or sector or index, the less time is required for 'longer term' to arrive.
The exception to this rule seem to be economists, who never ever seem to 'get it right' until all the horses are out of the barn. To that extent they are roughly the equivalent of chief market strategists for the retail firms.
Posted by: Jesse | Oct 3, 2007 11:15:38 AM
"The S&P 500 peaked on July 16, 1990 after a 3.4% burst over the prior month and the recession began that very same month."
Yes, but the Soviet Union and the Berlin Wall was collapsing causing the start of massive defense job losses. And, just two weeks later Iraq invaded Kuwait and oil shot up to a record $40 a barrel throwing us into a prolonged recession
Posted by: Larry Nusbaum | Oct 3, 2007 11:19:23 AM
If equities markets were a discounting mechanism they should have rocketed up in 2004 and yet they were sluggish, this was the perfect time for acquisitions and yet they were very few.
There is as well a phenomenon which is totally ignored the abundance of parasites in the markets(derivatives), equities, interest rates which are giving a wrong pricing and whoever is flying will only see prices and index (the total amount of derivatives as recorded by BIS is 886 TRILLION USD)
If equities markets were a discounting mechanism the financial sector should have been much lower in price and expected earnings since 2006.
Posted by: Philippe | Oct 3, 2007 11:33:47 AM
As Fullcarry says, it matters what the market is discounting. It is not just discounting growth and general economic prospects, it is also discounting the medium of exchange for those prospects and the spread over alternative investments. Buying some stocks is a lot like buying commodities and rising share price can be seen as another form of inflation. A good deal of the implied projected earnings growth could just be nominal, not a projection of real growth, just higher prices for the same or even declining sales. Couple this with a belief that the fed will keep rates low and buying stocks becomes the best or only way to chase excess nominal yield. Russell says we might be headed into the big blow off phase yet. Compare Zimbabwe. http://www.mises.org/story/2532
Posted by: Doug | Oct 3, 2007 11:36:23 AM
Doug ...
This is clearly not Zimbabwe, but we do have a "growth at any cost" central bank here in the USA.
We will repeat the economic experience of the late 1970s.
Hell, we have already repeated the geopolitical experiences of the early 1970s.
It is all in the "nature" of the American character.
Posted by: esb | Oct 3, 2007 11:48:31 AM
To the bears all news, good or bad, confirms their views. Most of the events covered in the news have no correlation to recessions or the stock market.
Attention bears! Stocks are not in a bear market. If you like bear markets, focus on the US dollar. It seems to be in a picture perfect secular bear market.
Posted by: Werner Merthens | Oct 3, 2007 11:48:57 AM
Kudlow was terrifying. If I were Kass I'd demand a show of respect. Why do I allow Kudlow on my TV? The schedule change moves him off my radar.
Posted by: sanjosie | Oct 3, 2007 11:54:25 AM
Attention last poster! Stocks aren't pricing in the realities of the bond market. Stocks aren't pricing in the stone wall experienced in the ABCP market. Stocks aren't pricing in the realities of the housing market's tie to GDP.
Most of the events priced into the stock market have no correlation to the news.
Posted by: Unsympathetic | Oct 3, 2007 11:56:55 AM
werner... maybe you are jumping the gun.
there is no way of knowing whether we will enter a bear market or not? reason: unless all the data about high consumer debt is wrong, we are definitely going to see a slowdown in consumption.
and with all the bad news in the financials....and all that mark to model accounting can only stave off the bad news for couple of quarters not forever.
business spending is going to show some signs of decreased spending in the coming months thanks to all the bad news about economy etc..
so i would not say that we are out of the woods.....particularly when it is proven that stock market usually lag the real thing by atleast 6-9 months.
so bears and bulls....lets just be patient and as months pass by reality will reveal itself....so i guess its not such a bad idea to be in cash right now....except that it hurts when the markets keep going up despite all the negative data about economy.
Posted by: techy2468 | Oct 3, 2007 12:09:18 PM
Up and Comming?
The Twelve Days of Crisis
On the first day of Crisis the markets sold to me
A sub-prime bankruptcy.
On the second day of Crisis the markets sold to me
Two structured notes
and a sub-prime bankruptcy.
On the third day of Crisis the markets sold to me
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the fourth day of Crisis the markets sold to me
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the fifth day of Crisis the markets sold to me
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the sixth day of Crisis the markets sold to me
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the seventh day of Crisis the markets sold to me
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the eighth day of Crisis the markets sold to me
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the ninth day of Crisis the markets sold to me
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the tenth day of Crisis the markets sold to me
Hedge fund Boards all leaving
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the eleventh day of Crisis the markets sold to me
Over-hyped underwritings
Hedge fund Boards all leaving
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
On the twelfth day of Crisis the markets sold to me
Central banks succumbing
Over-hyped underwritings
Hedge fund Boards all leaving
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.
..all of which does omit, of course, “hysterical overblown relief rallies by equities”; “a craven capitulation on the part of monetary authorities to Wall Street’s narrower interests”; “disconcerting weakness at the long end of bond markets”; “rising inflationary pressure”; “the dangerous vulnerability of retailers to deteriorating consumer spending”; “flimsy fiat currencies”; “a scary succession of non-American national property markets waiting to soften, including but not necessarily limited to Australia, Belgium, Britain, Denmark, France, Ireland, Italy, Spain and Sweden”; and “defensive investing becoming paramount” – but then none of these coinages is particularly susceptible to rhyme.
http://thepriceofeverything.typepad.com/the_price_of_everything/
Posted by: Spcwby | Oct 3, 2007 12:46:39 PM
so bears and bulls....lets just be patient and as months pass by reality will reveal itself....so i guess its not such a bad idea to be in cash right now....except that it hurts when the markets keep going up despite all the negative data about economy.
Posted by: techy2468
Hurts like Hell.
Posted by: pj | Oct 3, 2007 12:58:38 PM
Spcwby for the win!!! (I particularly liked "Hedge fund boards all leaving. . .)
Posted by: XON | Oct 3, 2007 1:01:21 PM
If a PM scales back on his allocation to equities and a recession doesn't materialize, his performance will suffer. And PMs are acutely aware that underperformance leads to redemptions.
Since recessions are the abberation, I think PMs feel compelled to be positioned for the no recession scenario even when the probability a recession is increasing.
Only when they can no longer deny a recession will happen will they reposition the portfolio for risk aversion.
So, I think stocks are poor at discounting recessions not because the PMs don't see the risks for one rising, but because if they position for one and it doesn't materialize, the penalty (loss of assets under managment) is so harsh.
Posted by: Groty | Oct 3, 2007 1:02:39 PM
How can even a genius market measure and discount the size of the credit fall-out before us? If the extent of a problem is not yet visible, how can "the market" accurately price it? This whole "the market is a brilliant discounter" thing has been proven wrong in the past at the outset of secular shifts. The falling dollar, rising inflation paradigm of today is an era we have not seen for some 30 years. When you can't see the road due to thick fog, its just plain reckless to keep driving full speed ahead. Risk management demands waiting for some visibility before assessing probable outcomes. The market presently is being driven by reckless players boldly wielding a lot of other people's money.
Posted by: D. Park | Oct 3, 2007 1:07:18 PM
neccesity purchases
heard last week on the flavor of Christmas '07
Posted by: Greg0658 | Oct 3, 2007 1:25:03 PM
"Most of the events covered in the news have no correlation to recessions or the stock market."
Ha ha! That was funny!
Oh wait - you were serious?
Posted by: donna | Oct 3, 2007 1:30:12 PM
ESB
You are on the wrong board (you sound like a bull). TBP is primarily for (long suffering) perma bears.
Posted by: dan | Oct 3, 2007 1:36:10 PM
I think there are 2 issues here:
1) Everyone keeps quoting lagging indicators as a reason we won't enter a recession (like employment and stocks). Check out new home sales, part time employment, inverted yield curve (which sometimes steepens even as the recession starts), durable goods, etc. These and other leading indicators are all headed down. The lagging indicators are still mixed, which the Bulls somehow interpret as "good news."
2) The market runs on far more emotion than logic. As Barry pointed out, how can the NASDAQ be worth both 5000 and 1500 within a 2 year period? It makes no sense ...and I would insist it is not mis-valued only in bubbles. Buffet has made the 2nd largest fortune in the world over the past 40 years buying undervalued companies.
Posted by: NoFate | Oct 3, 2007 1:53:22 PM
dan... it will make more sense if you answer any of the comments (try to answer noFate most recent comment) rather than branding "PermaBear" or PermaBull or whatever.
i invite the bulls to bring some reason and some logic......rather than simple empty rhetoric that
* market always goes up
* only way to beat inflation is to stay away from cash
* since we are not into recession right now means we will not go into recesssion (the reason why equities are cheap)
i am beginning to think if Bulls ever use any kind of logic rather than just being strong headed and running into the market will full force??
i am begging all positive thinkers to shed some light on all the negative news...i love contrary views.
Posted by: techy2468 | Oct 3, 2007 2:11:17 PM
techy,
Housing prices topped out in August 2005. This housing slowdown has been so slow moving that it has allowed the other sectors of the US economy to compensate.
Checkout the booming agriculture, healthcare, education and export sectors.
Also check out:
http://www.econbrowser.com/archives/2007/10/not_all_the_new.html
Furthemore, the yield curve has been steepening. Foreign economies are booming. And most importantly personal income is growing smartly.
I can go on....
So as long as interest rates stay low there is no reason the US can't muddle through.
Posted by: Fullcarry | Oct 3, 2007 2:23:43 PM
