Awaiting the market's rude awakening

Markets are currently breaking every economic theory in the book, rising on bad news and falling on good. There are fundamental reasons this won't last.

Global financial markets remain skittish. Worse than skittish actually, as there remains a perverse reaction to fresh economic news that would drive most year-12 economics teachers to despair, because their best economic theories are being proven wrong in the real world.

At issue is when there is genuinely bad news on the economy, it is treated as a positive for financial markets while good economic news is treated as a negative. This is because bad news is seen to be confirmation that the US Federal Reserve (and other central banks) will maintain an aggressive program of quantitative easing, printing money and boosting liquidity. For markets, this reaction to bad news keeps pushing stock prices high.

There was yet another example of this overnight in the US markets. 

GDP growth for the first quarter was revised down to a tepid 2.4 per cent from the initial estimate of 2.5 per cent. While not a big revision, it was in the wrong direction for those looking for confirmation of a more robust recovery. At the same time, initial jobless claims rose by 10,000 to 354,000, missing the consensus forecasts for a fall. An important housing indicator, pending home sales, rose just 0.3 per cent in April to again fall short of expectations, which were for a rise of 1.5 per cent.

All together, the news was a little disappointing.

The markets, however, saw the news as confirmation that the Fed will maintain its hefty QE a while longer. Stocks rose, with the S&P 500 index up a solid 0.5 per cent to close a touch below a fresh record high.

In recent weeks, the opposite has happened with genuinely good economic news opening the possibility of an end to the super stimulatory monetary policy. The better the economy performs, the more likely it is that the Fed will start to scale back its money printing.

Various Fed officials, including chairman Ben Bernanke, have also noted the fact that QE will have to start to be scaled back at some stage. The mere mention of what is obvious and in a sense a truism, the stimulus cannot last forever, is met with sharp fall in stock prices even though it would only happen when the economy was on a surer footing.

If this sounds bizarre, it is.

Genuinely bullish markets for stocks are based on sustained strong economic growth with moderate inflation. This combination drives a lift in the volume of turnover in the economy (by definition) with moderate but increasing prices (inflation) leading to ongoing profit growth and hence rising share prices. 

This is how stock market valuations work, at least they do over a medium-term time frame. In other words, a recession is almost always accompanied by a bearish stock market and a boom in economic conditions is inevitably accompanied by a stock market surge.

Which comes back to the point that very little of the recent gains in share prices is due to earnings growth. From a macroeconomic perspective, this is not sustainable, even though many firms have boosted their top line profits with cost cutting.

Stock market increases are best and most sustainable when they are driven by higher turnover, earnings and profits from expansion, rather than from cuts to spending or speculative buying.

The current phenomenon being encountered won't last forever. It cannot. Eventually the fundamental position of corporate profits and economic growth will prevail or dare I say, markets will realise that sub-optimal economic growth just is not delivering sustained increases in profits and earnings and as a result, stocks will fall back to earth.

But in the interim, the hang over from worst economic conditions seen since the 1930s Great Depression mean the markets will remain dependent on the pump priming of the Fed and other central banks. 

It is to be hoped that there is some real traction in the economy in the not too distant future and some fundamental justification for the current bull market in stocks. If not, what we are seeing with the Dow, the FTSE and other European stock markets holding near record-highs will come tumbling down.

That is certainly a risk in the near term, but curiously the biggest threat to the bull market is a run of better economic news. Strange indeed, but for my old economics teacher, a nightmare that just does not fit the theory.