Yesterday’s market action was anything but normal and likely driven by massive short covering and unbridled optimism (read, confusion) over the state of the U.S. economy. There was no real positive news. In fact, the news of the day was that CIT was on the brink of failure. That news would have sent the market over a cliff 6 months ago, but optimism has kicked pessimism down the stairs – for the time being. David Rosenberg points out that the rally was built on nothing more than Meredith Whitney’s commentary, which was actually an overall bearish call and a company specific bullish call:
We thought that the ability of one person to move the market went out three decades ago with Henry Kaufmann over at Salomon Bros., but Meredith Whitney did manage to do the same — in a bullish fashion, though — with her CNBC remarks on Goldman yesterday morning. (Although, it was interesting that Dell’s reduced guidance for the current quarter garnered little attention.) What was interesting was how she stressed that this was not an industry-wide comment but rather specific to the firm and yet this was the tide that lifted all boats across the financials and the entire stock market for that matter. What this tells us is that even after 12 years of no appreciation in equities, and after brutal bear markets seven years apart, the public’s resolve in the stock market has not been shaken. The fact that the equity market could rally this much based on one analyst’s commentary is testament to the view of how badly investors want to believe that the recession and credit crunch are behind us and that unbridled prosperity lies ahead. As WTO Director-General Pascal Lamy said yesterday, “I would caution against excessive optimism.”
What’s more worrisome is that investors are bidding up stocks in anticipation of “better than expected” earnings. Regular readers know that I became increasingly concerned about earnings as the official start of the season approached. I knew the banks would generate better than expected reports and wouldn’t dampen the party with their guidance since banks don’t provide guidance. It was the deciding factor in my move from a bearish stance established at S&P 945 to a neutral stance at S&P 890. The real problem, though, is that the underlying earnings are not nearly as strong as the bottom line might imply. Revenues are still deteriorating at a furious pace. The only thing keeping the bottom line from plummeting is the unsustainable cost cuts across the board.
So what are the implications? As I mentioned, the banks always lead off earnings season, but they don’t give guidance. Don’t be shocked when we get more results like Goldman’s although not nearly as strong. But don’t be fooled. Anyone who believes the U.S. banking system has been cured is a fool. The banking system will be crippled for years by these asset impairments and change in business model. The 90’s are not coming back (unless you’re Goldman Sachs and you press on the risk accelerator like it’s going out of style). I believe the market can continue to rally as the banks release reports, however, once we get into the thick of earnings season and we get numbers from the retailers and materials firms the true weakness in the economy will once again begin to show. I believe the market is placing a short-term trade on fundamental drivers that are questionable at best. Don’t be shocked if this market were to roll over like a well trained dog as we get deeper into the earnings season. For now, the trick to buying stocks is to be the guy/girl who is NOT holding the bag at the end of the day – for that day is coming.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.