It’s All About Confidence in the Market

Ouch! US stocks fell hard overnight, with the benchmark S&P500 falling 1.26%, its biggest decline in months. The Australian market followed it down, with the ASX200 down 50 points at the time of writing. Why investors decided to sell today and not yesterday, or last year, is anyone’s guess. According to the Financial Review, the punters are becoming a little nervous about company earnings.

Company earnings you ask? What are they? Well, they are the fundamental driver of stock prices. Sometimes the market chooses to ignore them, which is what happened throughout much of last year. And sometimes the market worries about them, which seems to be what’s happening now.

What’s bringing this to the fore is a spate of companies lowering their earnings guidance, before they actually report earnings. Part of the game on Wall Street is for the ‘investor relations’ people to hand feed earnings guidance to the analysts in the lead up to the actual earnings announcement.

Then at the time of the announcement, the company heroically ‘beats’ expectations, and so gets some good PR for the next day or two. As in, ‘ABC reported quarterly earnings of 21 cents per share, beating market expectations’. ‘Beating expectations’ has a nice, superior ring to it. It builds confidence in company management and encourages investors to buy the stock. Which is the whole point of the exercise.

But if you’re going to beat expectations you have to sometimes lower them, which is what appears to be happening now. As the Financial Review reported today:

Almost 10 out of every 11 earnings pre-announcements for the current earnings season from S&P 500 companies have lowered estimates, according to Thomson Reuters data.

Various companies that posted weak earnings or forecasts on Monday, including SodaStream, Lululemon Athletica, Express and Aaron’s saw their stocks get hit hard.

Let’s put this into perspective though. The S&P500 has hardly been too worried about earnings or any other fundamental driver for the past five years or so. Its focus is primarily on the Fed and how much play money it’s pumping into markets. To be fair, earnings have recovered sharply since their 2009 lows. But in recent years the gains have been less stellar.

Check out the long term chart of the S&P500 below. Does it look like it’s at all concerned about anything? Not since 2009, anyway.

click to enlarge

In short, the market has been on a tear for five years. It’s gone nearly vertical for the past 12 months without a decent correction. It could decline more than 10% and still look healthy from a long term perspective.

We’re beginning to sound like our mate Kris Sayce over at Money Morning. He’s been bullish throughout the 2013 bull market and remains so. He’s been right and we’ve been wrong.

But don’t worry, we haven’t changed our tune. We still think this whole financial system is built on a house of cards. It will come crashing down. Saycey doesn’t think that’s about to happen anytime soon. He thinks any correction will be met with more central bank help, and that equities will continue their run higher.

We’re not as confident in making that call. Equities have already had a massive run. So we’re happy to disagree with the resident bull on that one. But we can’t disagree with one of his recent stock picks, which rose strongly yesterday on the back of Indonesia’s export ban on unprocessed ore. The ban is an attempt to encourage companies to build smelters and refineries in Indonesia, but should boost demand for Aussie nickel and bauxite producers, at least in the short term.

Getting back to the global house of cards masquerading as a functioning financial system…what could be the breath of wind the knocks it down?

The answer to that question is a complex one. It’s not so much a singular event as a confluence of events. Those events are in play now, but will only become apparent with hindsight. The bottom line is that the house of cards falls when the market loses confidence in the ability of central bankers to control prices.

Clearly we’re not at that point just yet. But it probably won’t take too long to shift investor perceptions and risk appetite from one extreme to another.

The current perception is that the Federal Reserve is all-powerful. Their balance sheet is now over US$4 trillion, up from less than US$ 1 trillion before the crisis got underway. But the derivative market – that unwieldy beast of a thing where trading sets the price of nearly all financial assets – THAT is a multi-hundred trillion dollar market. The Fed has no hope of controlling it if things get out of hand.

You nearly saw a derivatives market blow-up in 2008. When insurance giant AIG was on the brink Goldman Sachs stood to lose a lot of money. Goldman had bought insurance from AIG that protected them from falling mortgage security prices. But AIG couldn’t pay when it needed to. It didn’t have enough capital and couldn’t raise funds from the money market.

From memory, Goldman stood to lose around US$13 billion. Such a loss would’ve caused a big hit to its shareholder equity. It could’ve caused a run on the banking system, as bank ‘equity’ is essentially the last line of defence for bank losses before it goes into bankruptcy. 

So the government moved in and bailed AIG out, thus rewarding idiotic behaviour. Many justified it as necessary to ‘save the system’. But what exactly has been saved? The ‘system’ promotes highly risky behaviour because of the perception of an almighty Fed and a government willing to avoid systemic problems at all costs.

But it’s exactly this type of behaviour that will lead to the system’s demise.  
So where will capital seek refuge when it does crumble, or when the market senses that it’s the beginning of the end?

Cash is Vern Gowdie’s bet. What about government bonds? Maybe, but this time around governments will be part of the problem. Precious metals and commodities? You bet.

Equities? Yes. But in our view, not before a decent correction. The financial system still benefits from confidence. There is no imminent stress in the system, although China is a looming problem of unknown magnitude. So we’ll likely continue through 2014 with the vast majority of people thinking that the system has another 40 years in it.

But you know different. You know that it’s a house of cards, and when investor confidence eventually starts to evaporate, the house will start to wobble.

Greg Canavan+
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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