On a fundamental basis stock prices are reflective of both economic and earnings
growth. When growth is strong, stock prices should increase in value. And when
economic activity decelerates or turns negative, stock prices should go down.
Of course nothing is that simple -- especially today, when all markets are
so highly manipulated by governments and central banks. Beginning in 2008 the
markets followed the Fed on a magical journey down the rabbit hole into a wonderland
where bad news is good news; and economic fundamentals and stock prices no
longer move in tandem.
Welcome to the worldwide equity bubble brought to us courtesy of central banks,
which has caused the complete decoupling of stock prices from underlying economic
activity. This delusion has been fomented by the specious notion that QE and
ZIRP will eventually cause economies to catch up to record-high stock valuations.
Perhaps the best example of this fiction is the nation of China, where the
ride on the command and control economy has left the communist country perched
atop two massive asset bubbles. One in real estate, whose foundation is empty
cities, and one in the Shanghai Index, whose value is based on companies that
have, at best, questionable accounting practices. But why let a lot of manipulated
facts get in the way of a really exciting asset-bubble story. For an exploit
in pure froth, China doesn't disappoint.
Let's take a look at the recent deceleration of China' GDP growth compared
to the frothy bubble in the Shanghai Composite over the past year:
China's Shanghai Index:
It's clear the Shanghai valuation has completely fallen off the economic tracks--as
the stock market has been accelerating into decelerating growth. In early March,
Beijing cut its gross domestic product (GDP) growth target to "around 7 percent" for
2015, the lowest level in 11 years. Official data also showed China's exports
unexpectedly plummeted 14.6 percent year-on-year in March. But the bad news
doesn't end there; growth in factory output slowed to 6.4 percent in the first
quarter from nearly 10 percent in December. And that officially reported 7
percent GDP growth in Q1 of this year is the lowest growth rate since 2009.
Despite this, the Shanghai Index is at new highs--up 30% YTD and over 106%
YOY. This because investors, hesitant to build additional empty cities, are
finding new hollowed investments in equities - creating a massive bubble in
the stock market.
Adding to the fun, Shanghai traders now have more than 1 trillion yuan ($161
billion) of borrowed cash fueling this high-flying stock market. The outstanding
balance of margin debt on
the Shanghai Stock Exchange is at an all-time record high and accounts for
nearly a 400 percent jump from just 12 months prior. Perhaps that is why Chinese
regulators recently placed curbs on the shadow banking system's ability to
purchase equities on margin.
Although China may sit as the best example of equities decoupling from economic
fundamentals, it's far from the only one. Japan's NIKKEI Index has skyrocketed
up 40% year-over-year, and is up almost 14% year-to-date; despite recent data
that confirms the nation is fast turning into one big retirement home.
Japan's NIKKEI Index:
In the U.S., where growth has been lack-luster, the total market cap for stocks
is hovering around 127 percent of GDP, far above the 110 percent level seen
just prior to the housing and credit bubble collapse and a full 75 percentage
points above its multi-decade average. And with NYSE margin debt for February
2015 at $465 billion, it is also at an all-time record high. Why not borrow
money to speculate on stocks when the cost of borrowing is at a record low?
Then there is Europe. Since QE began stocks have been surging. In France,
the CAC 40 is up 20% this year, while real GDP was up 0.1 percent in Q4; and
projected to be up just 0.9 percent for all of 2015. The German DAX up 25%
YTD and 31% YOY; yet industrial production was down 1.6% YOY in February.
And despite Mario Draghi's bubble-denial syndrome, the bubble in European
bonds has now hit the manic stage; as 30% of European Sovereign debt is now
trading with a negative yield. The world-wide bond bubble has now dovetailed
perfectly into a massive global equity bubble.
While world-wide markets are cheering central banks QE--sending stock markets
sky rocketing--our Fed is quickly running out of credibility and tools to fight
another economic downturn. Zero percent interest rates for 7 years and a $3.7
trillion QE bail-out from the Great Recession have not done anything to improve
economic growth. Central banks have merely re-inflated old bubbles and then
created a new one in global sovereign debt.
But what happens when investors reach the epiphany that all of the central
banks' interest rate manipulations and money printing didn't work? The U.S.
Federal Reserve isn't able to lower interest rates any further. Furthermore,
our central bank is growing exceedingly anxious to unfurl its own "mission
accomplished" banner on rescuing the economy and to begin the journey on rate
normalization with the first rate hike in June.
But if the economy were to enter into a recession at this point how would
the stock market and economy respond? Seven years of ZIRP and QE didn't help
the U.S. economy achieve "escape velocity", so why would the holding in abeyance
of the Fed's interest rate liftoff this summer, or even another round of QE,
automatically send stock prices higher?
Ever since the end of the Great Recession in June of 2009, investors have
full-heartily bought into the belief that central banks will eventually cause
economic growth to catch up with equity valuations. To date investors have
been willing to excuse sub-par economic growth, such as March's abysmal Non-Farm
Payroll report, on the weather. The Empire State Manufacturing Survey for April
showed a month-on-month negative reading of 1.19, giving credence to the belief
that economic growth has currently completely stalled.
An objective look at the above charts and data clearly depicts that equity
values have become completely divorced from economic reality. The catalyst
for the next major collapse in stocks will come from an impending recession
that central banks and governments will be viewed as powerless to prevent.
If April's better weather doesn't come along with a spring economic recovery,
investors will have finally run out of excuses and will have to face the truth
that after seven years of market manipulations the government has failed to
engender sustainable growth -- both Q1 and Q2 GDP and earnings growth could
be hugging the flat line for the first time since the second quarter of 2009.
Therefore, without an immediate improvement in Q2 data, the erstwhile view
of only a temporary disconnect between economic fundamentals and equity prices
will become one of indefinite duration. And this should finally cause the massive
correction in equity values that is so very long overdue.
