A Madoff Market

stockmarket002Fantasy is fun while it lasts. But reality eventually intercedes and interferes with even the mildest fantasy. Those way out in fantasy land are especially vulnerable to disappointment. So it is for those betting on the stock market and an economic recovery.  

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There is no economic recovery despite all the media and Washington bravado. Just another sign is the latest earnings reports. They are weaker than expected. (What kind of world do we live in when the best and brightest — our political elite and their cronies in the media — are consistently suprised and always in the same direction? Even the dullest among us know to change behavior or expectations when we are consistently wrong.)

In our topsy-turvy world of government-in-wonderland economics, myths buttressed by phony statistics and smoke and mirrors is the rule. Reality does not seem to matter. Here is Zerohedge's lead into the earnings shortfall:

One can stretch and spin the Q4 earnings reality to suit their particular sales pitch, or one can look at the facts. And the facts, as we first showed a week ago in "Q4 Earnings Season: Far Worse Than Most Suspect", is that before the start of Q4 earnings, the S&P 500 was expected to make $25.51 in earnings. Three weeks later, after half the companies had reported, the number declined to $24.03, with some $9.70 of actual reported earnings and the balance estimated. Now, a week later, the latest revision shows even more deterioration in earnings, which with 66% of companies my market cap reporting are now just $23.48, 8% lower than the estimate at the start of earnings season, with under $10 of earnings left in estimated EPS and the balance already in the books. As Goldman explains what this means for earnings on a year over year basis: "Our interim revised 4Q 2012 EPS estimate is now $23.48 implying negative 1% growth versus 4Q 2011 ($23.73)." 

Friday the Dow closed above 14,000. CNBC and other Wall Street cheerleaders proclaimed a new bull market. Happy Days (or is it Daze?) are here again. 

There is a massive disconnect here. How can one have a bull market without an economic recovery or without earnings growth? In an honest world, you cannot. But "honest" is no longer applicable to the world in which we live. Nor is ethics or the law.

The Short-Term Importance of P/E Ratios

The stock market and the economy are two different entities and often diverge. Most short-term stock market moves are not generated by earnings. Ultimately earnings determine the value of a stock, but major stock market moves occur with changes in the P/E ratio. The expansion or contraction of this ratio, rather than earnings, generates movement. Earnings changes, at least for the overall market, do not change by 40 - 60% in twelve months. Yet we see swings in prices moving that much. No major short-term  market move, either up or down, can be explained by the E in the P/E ratio. The move always results from an expansion or contraction of the P/E. 

The P/E multiple might be viewed as a measure of confidence or optimism. If it expands, then presumably future earnings are expected to be larger than current earnings, hence the price (and P/E rises). Just the opposite occurs when future earnings are anticipated to decrease. Expectations, in an honest world, would suffice to explain market swings.

But we have just seen an example where earnings expectations are being revised downward and the market is going higher. On top of that, the economy shows no sign of economic recovery and the debt crisis cannot be solved. What explains the apparent contradictions?

The answer is duplicity. We live in a world manipulated by government interventions. Whether it be bailouts or liquidity, the rules of society have been altered. Lying about economic statistics is now acceptable. Fudging earnings reports to achieve a proper EPS pattern also is winked at. Jon Corzine can have billions of dollars disappear on his watch and not even be investigated. The corruptness of the system is stifling. But the biggest culprit is the Federal Reserve.

The Fed is increasing its balance sheet (and hence the base money supply) by a Trillion dollars per year. That money has to go somewhere. It can go into financial assets or real assets. Real assets are not increasing in supply, nor much in price. That suggests that the excess liquidity is going into financial assets. They too are reasonably constant in supply in the short-run so that increased demand (generated by funds looking for a place to go) drives up asset prices. That is exactly what is happening. 

Major changes in P/E ratios are almost always correlated with changes in the rates of expansion in the money supply. 

A Madoff Market

Given the economic outlook, there seems little reason for stock prices to be as high as they are. However, as John Maynard Keynes once observed (one of his true observations), markets can remain irrational longer than you can remain solvent. This market could be called a "Madoff Market" in the sense that it is a Ponzi scheme. It is not the classic Ponzi scheme where exponential growth of new dupes is necessary to keep the scam going. This one, does not depend upon new suckers but on exponential money creation. 

Unlike a traditional Ponzi scheme, this one is difficult to determine when it will end. There are no physical constraints like new buyers that must eventually fall short of what is needed. This one is dependent on paper and ink (more properly electrons these days) which are readily available in large quantities. When one considers that the denominations which can be imprinted on the paper, the potential fuel for this Ponzi scheme might be considered infinite. 

For a while, that may be true. At some point, however, either politics or markets will terminate the fraud. If the heat becomes too great for the political class, they will stop the Fed. That is probably unlikely.

More probable is that high inflation, possibly hyperinflation, makes the dollar increasingly less acceptable to merchants here and abroad. At that point, the efficiency of a currency-based economy moves toward the inefficiencies of a barter-based economy. New dollars lose their effectiveness and economic activity shrinks.

Whether it is either a political shutdown or a market showdown, the end is the same — a Depression.

The problem is that this end is tougher to forecast than the average Ponzi Scheme.

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