It is a source of considerable annoyance (and sometimes amusement) to all serious investors that two years after the flight of many household and institutional investors the much reduced daily trading volume is dominated by hedge funds and “prop trading” desks, manned by relatively young and often rather inexperienced momentum traders. Having no real knowledge of either the intricacies of macroeconomic data nor the inner workings of corporations, their ultra shortterm focus merely reacts to the daily news flow and, often in their quest to scalp a few pennies, they make the wrong move. Decimalization and the removal of the uptick rule have combined with electronic trading to create volatility all out of proportion to the significance of the daily data releases, most of which are merely “noise.” Sometimes these trends can last a few days, long enough for a new investor consensus to develop, only to reverse suddenly and cause stocks to change direction. The huge growth of industry-specific ETFs also magnifies these volatile but trendless short term movements.
In recent weeks the price of crude oil has risen by about 50% for both Brent and WTI. Many are quick to place the blame at the feet of the Federal Reserve Board, arguing that QE2 has weakened the Dollar and caused a flight to hard assets. While there may be some validity to that claim, other more important factors are also at work, including surging demand from the emerging economies, curtailed supplies from the Middle East as well as the Gulf of Mexico, and the magnification of these trends by speculators. The evidence of the large open interests on the commodity exchanges proves that speculative activity is playing a major part in both the frequency and the amplitude of price moves among these commodities, which in turn is reflected in the price volatility of the underlying equities. But surging oil prices, along with agricultural commodities, give rise to inflationary fears, which then cause interest rates to move up, thereby negatively impacting the present value of equities. Also, of course, as the primary Government bond dealers prepare their books for large offerings of Treasury Notes and Bonds, yields inevitably rise, only to fall back again once the auctions are completed.
The bears also raise the argument that nobody will be around to buy new issues of Treasury securities once QE2 ends in late June. We simply discount that notion. However, the very public dissension among members of the FOMC regarding QE2 certainly heightens investor concerns, as does the comedy of errors playing out in Washington in the battles over the fiscal deficit, the nation’s debt to GDP ratio and the need to raise the debt ceiling. If there is a modest uptick in inflation, with no follow through in terms of much higher private sector borrowing or wage growth, then the recent inflation hysteria will prove to have been excessive. While all of these inflation fears were playing out in early April, the stock market held its ground quite well, and even at this writing is down less than 1% for the month and is still up nicely for the year-to-date.
However, the next iteration in this schizophrenic drama has concluded that higher oil and other commodity prices are a tax on the global economy that will inevitably slow global growth. When the IMF, not well known for the accuracy of its forecasts, downgraded global prospects for 2011 by a modest amount, prices of all commodities tumbled, and this led to a rout in commodity related equities over the past few days. These had been among the leading performers for a long time. Investors and traders had large unrealized profits in these groups, and the stocks being quite liquid were relatively easy to sell by those who suddenly feared slow growth rather than inflation.
Next week investors will get back to reality. The earnings reporting season will be in full swing, and the focus will shift away from all this background noise to the real fundamentals. Since there have been few significant preannouncements (typically disappointments), we expect another strong quarter to be reported for corporate revenues, margins and earnings. Even with all the issues that affected GDP, including the tragedy in Japan, the turmoil in North Africa and the Middle East, higher energy costs, the harsh winter weather, the late Easter this year, etc., the numbers are likely to exceed consensus expectations in a majority of Q1:11 earnings reports. Given all the background noise, however, managements are likely to be conservative in their forward guidance for the balance of this year.
Nonetheless, the Standard & Poors 500 appears to be on track to produce profits of about $95 per share this year, give or take a small amount. If the Fed terminates its extraordinary stimulus in June, as appears likely, it will be a sign that the economic expansion has become self sustaining. Interest rates will likely move up somewhat in the absence of purchases and ultimately some asset sales by the Fed, but they would have to move much higher than current levels to impede the economic expansion. Indeed, some argue that higher interest rates will stimulate both borrowers and lenders to increase private sector credit. Savers will also benefit from higher yields. It is a political imperative for both the developed economies and the emerging economies to keep the global economy on an expansion path. The riots in the Southern European countries and the turmoil in North Africa and the Middle East are clear signs to the politicians that permitting another global recession is simply not an option. Even if corporate BBB bond yields move from about 6% currently to 7% on average, equities with nearly an 8% forward earnings yield, and with upside over time, are still by far the better bet. And even if nominal GDP growth begins to exceed M2 growth in this country, there is still a mountain of sideline cash that needs to participate in equities. Last year the average hedge fund with a 2%-20% fee structure barely returned double digits from all that useless short term trading. Pretty soon, serious investors will begin to look through the nonsense of this activity and realize that this global expansion and bull market in equities still has a long way to run.
