Think Like a Rat

Experiments show that if you put rats in a maze and give them a jolt of electricity when they go the wrong way, they will eventually go the right way.

Apparently, humans may not be that smart.Two white laboratory rats in a maze

OK, we’re smarter than rats.  We know better.  But we believe what we want to believe.  And right now, a majority of those who invest believe the “trend is our friend.”

We forget that what goes up must come down, regardless of how many bonds the Fed buys.  It’s a scary world and no amount of irrational investor confidence can keep the market aloft forever.

In the first decade of the new millennium, we lived through two difficult bear markets, each of which chopped stock prices nearly in half.  The bear market of 2000 to 2003 was caused by the irrational belief that tech stock prices moved in only one direction.  The bear market of 2007 to 2009 was caused by the irrational belief that housing prices moved in only one direction.

So here we are just five years removed from the last bear market and investors are acting as though stock prices move in only one direction.  Investors have already forgotten that bubbles burst.

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Translating Fedspeak

While the week’s biggest news has taken place in Russia, Ukraine and China, it’s the news out of the Federal Reserve Board’s Federal Open Market Committee that’s most in need of translation.

The Fed regularly uses language that no one understands, because if America’s taxpayers really knew what’s been happening, they’d totally freak.  Keep that in mind and proceed with caution as we attempt a translation of Fedspeak from new Chair Janet Yellen’s first press conference:

“ … the FOMC’s outlook for continued progress toward our goals of maximum employment and inflation returning to two percent remains broadly unchanged.”

The dots are moving and we’re not achieving the results we expected, but you won’t hear it from me. Yellen 2

“Unusually harsh weather in January and February has made assessing the underlying strength of the economy especially challenging.”

The economy still stinks, but we’re going to blame it on the weather.

The unemployment rate, at 6.7 percent, is three‐tenths lower than the data available at the time of the December meeting.  Further, broader measures of unemployment such as the U6 measure, which includes marginally attached workers and those working part‐time, but preferring full‐time work, have fallen even more than the headline unemployment rate over this period.  And labor force participation has ticked up.

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Fundamentally Flawed

Imagine if the outcome of a football game depended more on the weather than on the talent of the players.

Weather, indeed, can have an impact and should, but its role is usually to test the talents of the players, not to be the primary factor in the outcome.  When it is the primary factor, anything can happen.  In such cases, would you put money on the game?

The weather is not the number one factor affecting the performance of the stock market these days, but neither is the talent of the players – that is, the fundamental performance of publicly held companies.

In recent years, The Federal Reserve Board has held sway over the market’s performance via quantitative easing, although under former Chair Ben Bernanke, it was somewhat more predictable than the weather.AUDJPY

Now, with tapering under way, that may change (we’ll see, as many expect plenty of bond buying ahead).  Yet other world events may replace QE in determining the performance of the market.  That means potentially greater volatility than we’ve experienced in the easy money era.

It doesn’t take much to affect today’s global economy, especially when the impact of events is amplified by high-frequency trading.  Consider, for example, the impact of the falling yen and Australian dollar on the S&P 500.

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We’re All Debtors Now

You’ve probably heard that corporate America is swimming in cash.  Something like $4 trillion worth of it.  And once corporate America starts spending it, the economy will boom again, jobs will be created, GNP will soar and the stock market will boom ever higher.

Corporate cash is the good news.  Corporate debt is the bad news.

While cash is at record levels, corporate debt now exceeds the level it was at in 2008 and 2009.  In case your memory is really short, that’s when America was wondering whether its financial system would survive.Corporate Debt

But temper your nostalgia for those bad old days.  When we say “exceeds,” we mean that corporate debt is 35% higher than it was then.

Net debt – what you get when you subtract cash from total debt – has been climbing steadily for American companies since 1998, as the chart shows.  It doesn’t mean corporate America is insolvent (not yet, anyway), but it does have nasty implications for future corporate growth, profitability, unemployment and income growth.

Given all of that cash on hand, some are making heady predictions about accelerating capital expenditures.  Goldman Sachs’ David Kostin predicted that capex spending will grow 9% in 2014, compared with 2% growth in 2013.

He may be right, given the need to replace aging and outmoded equipment, but a prediction is only a prediction.  And more capex spending will mean less cash for paying down corporate debt.

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