Fighting the "Fundamentals"

How should one interpret the market rally?

One widely-held viewpoint is that the rally has occurred despite weak fundamentals.  This means the market is over-extended and due for a correction or even a crash.  Those taking this position cite continuing high unemployment, a continuing high rate of foreclosures, threats to commercial real estate, the "spent-up" consumer, high debt levels, and a generalized concern about government policy.

These have all been the factual backdrop for many months.  These factors have not changed.

Another Approach

An alternative viewpoint is that the US equities in March reflected a worst-case scenario, revisiting depression conditions.  If conditions -- still bad -- improved from those levels, then many individual stocks deserved higher valuations.

What has changed since March?  Two things - -both important.

Forward Earnings.  Ed Yardeni follows the forward earnings estimates quite closely (subscription required).  He writes as follows:

Earnings are turning. S&P 500 forward earnings is turning up rather nicely and consistently since it bottomed at $62.92 per share during the week of May 8. Last week, it was up 12% from the bottom to $70.49. It’s up for 17 weeks in a row to the highest level since January 23. As 2009 ends, forward earnings will converge to analysts’ consensus expected earnings for 2010. This estimate has also been moving higher from a low of $73.37 during the week of May 8 to $75.29 last week

Interest Rates.  Investors have a choice in asset allocation.  When there are extremely high corporate bond rates, this is an attractive alternative to stocks.  If one is taking a risk in buying corporate paper instead of Treasuries, the return should be compared to expected stock gains.

The Atlanta Fed does a nice job of summarizing many economic indicators.  Here is a recent look at corporate credit.

 

There is an obvious improvement in corporate yield spreads.  Lower yields make corporate paper less attractive in comparison to stocks.

 

Credit default swaps show the same picture.

Conclusion

However one defines the "fundamentals" it should not be a static concept.  The data show that stocks have less risk and more potential reward than was the case a few months ago.

Those choosing a static definition of the fundamentals -- looking at backward earnings, for example -- miss out on the changes in risk and reward.

Considering these data, one could easily make the case that stocks are just as attractive now as they were last Spring.  Prices are higher, but risk/reward is also better.

Comments

[Ho]

everyone has been wrong so far except the American bear!

[oldprof]

Andrew -- You have stated a widely-accepted perception, which I believe to be incorrect. Those sharing your viewpoint are exactly those that I am trying to help.

So I have two questions for you.

First, have you seen any analysis of analyst estimates over time? You might be surprised to know that estimates were lower than the actual results for many years. Sure, when Lehman collapsed a lot of forecasts were too high. Why do you think this has implications for next year?

Second, my main point is that looking backwards is static. If you go with backward looking data, you are unable to adapt to changing conditions, like those I cite in the article.

Do you really think that nothing has changed in the last six months? Your backward earnings estimates do not change, but the world has.

I appreciate your comment, which reflects what nearly everyone thinks. I am trying to stimulate something deeper.

Thanks,

Jeff

[Andrew McCauley]

Forecast earnings were off the mark on the way down & probably will disappoint on the way up.

I find that trailing earnings have a better predictive quality than forward earnings because they are minus analyst & investment bank bias.

[redvetttes]

its not getting no better,being an out of work industrial electrician train at ABB, GE, Fanic,Robots,plc's drives and automation.Headhunters call 3 times a week for job offer.Now nothing,Pick up the Buffalo paper and there were 14 help wanted ads,3 army 3 telemarkers and dishwasher.Still have 1 year of UI.left witch will keep being extended.The Goverment knows HUNGRY PEOPLE RIOT.When the Big Boys hand the market off to the retail investor short the living shit out of it!
Another wall street buble

[oldprof]

VennData -- You have repeatedly demonstrated a good grasp of interpreting data. One of my missions is to educate on this subject, and your comments are most helpful.

Jeff

[oldprof]

Market Sniper -

I carefully chose data that were non-government sources (the Atlanta Fed data is generally available market data). If investors choose not to believe any evidence, they will be locked into the broad, sweeping statements and non-quantitative assertions.

I am really trying to be helpful -- citing sound data.

The challenge to government -- well I disagree, but it is a subject for another day. The BLS provides data to allow us to see employment with several different definitions. They do this in an honest process. We all know that it is a bad situation. Investors should focus on the change, and the implications for earnings.

I always appreciate challenging questions on specific subjects.

Jeff

[VennData]

Which facts and figures are being manipulated? Do tell. How do you calculate your "true" unemployment (U-Market Sniper) via your own survey?

Your argument by analogy doesn't prove anything (as making arguments by analogy do not) since, well for one view, the economy "goes to Vegas" every week. And next week etc.

Also, you may not be doing well, but Vegas (which is part of "the analogy economy" is.) So together, Vegas and you are net zero.

Arguing by analogy as extrapolating that to Macro calls on the economy is story-telling. Nothing more.

[Market Sniper]

Hey, Jeff. I like your work. Would only partially agree with your assesment. I have deep distrust of the "facts and figures" being put out by the goverment and have more than just a feeling they are being massaged and manipulated. There is a total disconnect between Main Street and Wall Street. True unemployment now rest north of 20% and the highest percentage of Americans are out of work than anytime since October of 1948. We keep getting told that things are "getting better" because the rate of change in bad news is slowing down. That is like me saying "last week I went to Las Vegas and lost $100,000. this week I went and only lost $50,000. See? Things ARE getting better. Until the debt situation is dealt with both public and private, this economy is not going anywhere. We maybe just in the eye of the hurricane here. We shall see.