Even though George Soros is a devout socialist, he knows something about investing. He writes about a typical cycle in the stock market in his book The Crisis of Global Capitalism. He calls his theory “reflexivity,” but the general idea is that the stock market usually tracks profits closely until near the end of the cycle.
As the reader can see from the chart below, the variance in profits isn’t as great as that in stock prices. The two begin to diverge about halfway through the expansion. All that means is that the PE ratio begins to inflate because credit expansion by the Fed is pumping new dollars into the economy.
If stock prices remained tethered to earnings, stock prices would level off. To prevent that, the media send in the clowns. In a rodeo, clowns distract the bulls to prevent them from stomping the cowboy into the arena dirt, but in the market the clowns distract the investor. The clowns pull from their shirt sleeves old tricks to make the fundamentals look better. They use performance measures that rely on creative accounting, alternative profit measures, pro forma statements, and complicated valuation techniques. The clowns break the connection to earnings so that prices continue their ascent unrestrained by fundamentals. If the market was an actual rodeo, the clowns would be lynched for letting the bulls pulverize the cowboys.
The price momentum causes more investors to buy into the market and, as Soros’s graph shows, price-earnings ratios climb with stock prices. Higher PE ratios demonstrate that in a Fed regime of low interest rates, investors take on more risk. Price inflation may begin to rise, but economists and the clowns will find ways to reassure the public that they really aren’t witnessing price inflation. The trick is to separate food and energy from the data and report on “core” inflation, which tends to be less volatile.
A few people have noticed the disconnect between fundamentals and the market. Recently, US Commerce Secretary Wilbur Ross said of the 3% growth target set by President Trump, “it’s certainly not achievable this year.” GDP grew just 0.7% in the first quarter on an annual basis (multiplied by four). That means it actually grew from Q3 just 0.2%, the lowest growth in three years. Peter Schiff reported other warning signs:
There was weaker than forecast data on durable goods orders. Non-defense capital goods orders excluding aircraft increased just 0.7% in March. Analysts had expected 1.2% growth. It was the poorest showing in more than seven years.
The Kansas City Fed composite manufacturing index also crashed, falling from 20 in March to 7 in April. Analysts had expected only a modest drop to 17. Production plummeted from 37 to 12. New orders collapsed from 32 to 8. According to ZeroHedge, the average workweek shrank for the first time since November and the overall number of employees fell.
There are also some dark clouds hanging over the housing sector. Pending home sales fell 0.8% from February to March. According to the National Association of Realtors, the number of signed contracts to buy existing homes in March was just 0.8% higher than a year ago. According to CNBC, tight inventory and rapidly increasing prices are squeezing the housing market.
Affordability is clearly worsening, and that is sidelining more and more buyers. A report this week from real estate brokerage Redfin showed a drop in the number of home tours requested in March and the number of potential buyers writing offers. Mortgage applications to purchase a home are also weakening.
As we reported recently, the retail sector is in a free-fall, and the check engine light is also on for the auto industry. Then there is the ticking debt bomb.
When the market and fundamentals will make up and start running around together is hard to predict, but investors should begin to prepare for the event by using options or holding more cash.
Originally published on ABCT Investing.