David Tepper of Appaloosa Asset Management was on CNBC this morning reiterating his bullish call for stocks based on the Fed’s easing programs. Tepper, in case you don’t know, has been one of the biggest champions of the “don’t fight the Fed” stock market position. And he’s been very right. But I am not so sure he’s connecting all the dots here. For instance, here’s what he said this morning on CNBC:
“I’m definitely bullish. Look, ever see the movie cousin Vinnie? So there’s this moment at the end of the move where where he is making the case, summing it up. He sums up so many different things that the prosecution says, case dismissed. Because the evidence is so overwhelming. Kind of like that right now. It’s so overwhelming. Autos are better, housing is better. The fed, well, before we get to the fed, Australia just eased, Japan, Korea. These United States of America, we just are just amazed at the way these numbers work.
So really on the tv, on your show and others, there’s been talk about tapering. Tapering back to fed. So the market is worried about tapering. The numbers are quite amazing. Just truly amazing. The fed is going to purchase $85 billion of treasuries and mortgages a month. So over 500 billion in six months. What’s happened and what’s really amazing is that if you look at the incomes the next six months because of tax increases, budget cuts, growth in the economy and Fannie mae and Freddie mac paying back, the deficit is shrinking. This is something we can hopefully at least work on now. And i have the numbers. The next six months deficit will be well under 100 billion. Probably closer to 85. Which means — this is an important thing. For those people who say we have been financing the deficit, we really have — the fed will never say that. this is a pretty big issue. we have over $500 billion we’re going to buy over the next six months. now we only have a deficit less than 100 the next six months. the net issuance versus refunding is a little over 100. That means we have 400 billion, 400 billion that has to be made up.
So basically think about this. that’s being taken out of the market, out of the bond market. 400 billion is now in your hands, my hands and other folks’s hands. And there’s a few choices. It either has to go in the economy, which, you know, it probably will go somewhat in the economy. It has to go to the short end of the curve. The long end of the curve trade because we have this excess. Or it has to make stocks trade higher. The problem is you might be worried some of that might go into the economy and, you know, it might stimulate with a little bit of surge. Basically, afterwards, we also have to cut back because the deficits in the future will be less than this trillion dollars. so if we don’t taper back we will get into this hyper drive market. It’s backwards. the fed has to taper back. Because if you look at the numbers, it’s so tremendous, these numbers are so tremendous that you can have the market in hyper drive.”
That’s a lot to chew on. But the part that really jumps out at me is how money managers are just assuming that this money has to “move into” stocks which implies higher prices. But this confuses market dynamics. First of all, stock prices are a reflection of expectations for the underlying corporations. So, let’s say you have $100 in cash and someone is holding $100 in 1 share of GM stock and you guys exchange cash for stock. Then GM announces that its revenues fell 50% the following year. Let’s also say the Fed announces $100 in QE. Would you expect that $100 of Fed QE means that GM’s stock price will trade at the $100 level? It certainly might! But only if some bonehead is willing to purchase your 1 share at $100 even though the underlying cash flows of the corporation have deteriorated since you purchased it. More likely, the majority of investors will look at GM’s deteriorating income statement and wait for the stock to trade much lower than where you purchased it.
But the more interesting thing to think about is the sellers $100 in cash. Let’s assume he wants to replace his GM stock with something else that will earn a return. Does that seller automatically turn around and bid up stock prices just because he has cash? Well, he might, but that makes him equally boneheaded as the person who buys deteriorating GM stock at $100. The thing is, money doesn’t move into markets. It moves through markets. One person sells, another person buys, that’s why it’s called a “stock exchange”.
Now, what about when supply changes? As Tepper noted, we’ve got $400B in t-bonds and MBS coming out of the markets in the coming 6 months. And yes, the recipients of that cash will almost certainly be people looking to replace their lost return. So they’ll likely turn around and look at the available options. Could they buy stocks, bonds and other assets? Of course. But the price they’re willing to purchase those assets at should be contingent upon the underlying fundamentals of the entity that issued those securities.
Now, I am not bearish on the economy at present. In fact, I think Tepper’s right. The economy is improving. But what if that’s not the case in 12-18 months? What if the budget deficit shrinks so fast that it substantially weakens the economy? What if private investment slows? We’re still in a rather fragile state here. And if that happens the air pumped into the markets by this sort of positive irrational thinking (that you need to buy stocks regardless of their fundamentals and just because there’s nowhere else to go) will quickly turn into negative irrational thinking.
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