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I haven’t thought the 75%+ rally was particularly irrational over the course of the last 12 months.  Surprised by the strength?  Absolutely.  But irrational, no.  As of late, we’ve begun to see signs that the consumer is back, but the equity action implies that the consumer is not only back, but ready to break records.  In late 2006 I wrote a letter that said:

“So here we sit with a relatively healthy economy, signs of inflation and record housing prices. Sounds pretty good, right? Not so fast. The markets could certainly move higher if housing doesn’t collapse, but we see very few scenarios in which that can happen.  When the housing market slows consumers will spend less and businesses will begin to suffer. The US economy will then fall into a recession and European and Asian countries will quickly follow suit as the world’s greatest consumers wilt under the environment of low liquidity and higher debt….The credit driven housing bubble remains the greatest risk to the equity markets at this time.”

I said the market was due for a potentially crippling recession as the yield curve inverted, consumer balance sheets were turned upside down, and a housing bubble was brewing.  Just days before the market crashed in 2008 I said the market had all the ingredients for a crash.  In late 2008 I said the market had overreacted and would likely revert towards the mean in 2009 for a total return of 18%.

The day before the market bottom in March 2009 I said government intervention would likely generate an equity rally.  But I did not come close to predicting that we were on the precipice of a 75% 12 month move.  Not even close.  On the other hand, I have never thought the move was particularly irrational and didn’t fight the tape through 2009.

I was very constructive on the market heading into 2010 and maintained that stimulus, strong earnings and an accommodative Fed would result in higher stock prices in H1.  I point this out not because I am trying to toot my own horn or gloss over my many imperfections (many can be emphasized), but overall I have been able to not only foresee the macro mechanics driving the market, but have also done a fine job translating that into price action.

But where do we sit now?  We are beginning to see some glaring disconnects between the market and reality.  There are very real improvements versus where we were just one year ago.  The recovery is here and it has been stronger than I expected.  But there are also signs of irrationality on the fray.  This is nowhere more apparent than it is in the consumer sector.  The retail holders index is one of the few indices that has experienced a full-blown v-shaped recovery.  Just how wide is the disconnect between the consumer and retail stocks. Let’s compare and contrast 2007 and 2010:

  • We have lost 7.8 million jobs since then.
  • The unemployment rate is 9.7% versus 4.5%.
  • Total unemployed workers are now 15.7 million versus 6.5 million.
  • Real personal income less government transfers is lower by 6.5%, or $624 billion.
  • Real retail sales have rebounded just 4% from their lows and are still down 9% from the 2007 peak.
  • Consumer credit for February showed another sharp retrenchment of -5.6B.
  • Consumer bankruptcies for March were the highest level since 2005.
  • There is a glaring $1.5 TRILLION hole in the consumer balance sheet.
  • Home foreclosures surged 19% last month and are at their highest level since 2005.
  • The consumer’s largest asset (housing) is down 33% since 2007.
  • Meanwhile, the retail holders index (RTH) is back at its pre-recession highs.  Granted, the market is a discounting mechanism and this index has benefited greatly from retail expansion and improved corporate efficiency, but operating income at the index’s top 25 holdings is down 4.5% from 2007 and that’s including new stores!    This doesn’t rhyme with a near all-time high in the retail index.  This price action is acting as if the consumer is (or will become) whole again – which I believe is undeniably false.  Is the consumer on the mend and willing to spend again?  Most certainly.  Whether this is a good thing is a whole different debate, but as of now there are still few signs that the consumer is back to full strength or even close despite the market acting as though Goldilocks is here and ready to party.

    Of course, I’m talking my book as I sit on my first sizable short position in over two years (which has been a terrible call thus far), but the evidence appears clear to me.  This market is pricing in more than a Goldilocks recovery.  It is pricing in sheer euphoria and the data just doesn’t rhyme with such an environment.

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