Baccardax: Stocks Are the Only 'True' Market

The truth might set you free, but it comes at a cost, and the current tally is now running at around $10.4 trillion.

That's the estimate of market value that US stocks have given back since reaching their heady peak in October 2007 – a level reached, it's worth remembering, more than three months after the credit crisis truly came to life in the summer of that same year.

At the time, dyed-in-the-wool equity skeptics (such as your correspondent) were gleefully pointing to the myopic overvaluation of (levered) stocks in the face of near credit market paralysis.

Schadenfreude (delight in the suffering of others) is not a particularly attractive characteristic, but I must admit to experiencing a *tiny* bit of shameful joy when the relentless needle pricked its next bubble in the form of stock prices. I was, like most career fixed-income children, suspicious of equity valuations and held firmly to the Charles McKay ("Extraordinary Popular Delusions and the Madness of Crowds") school of thought that seemed to permeate the retail-investor driven indexes.

But like Saint Paul on his proverbial road to Damascus, I have seen the light.

Here's the truth: the only market functioning "like a market" at this point are global equities. Cash equity indexes around the world somehow managed to stay liquid through the worst of the Lehman collapse last fall, when the global financial economy almost literally came to a standstill.

Since then, excessive government involvement (I'm not comfortable with the pejorative "interference") and the collapse, near collapse or conversion of nearly every major investment bank on the planet, has made price discovery in other markets nearly impossible to trust.

Gold? Readers know my own bias, but most will need to concede that global financial markets are much *more*, not much less, disordered than they were in March of last year when the bullion peaked at $1,018 per troy ounce. Government ownership of gold, and the agreements they have with each other not to sell it, along with ancient inventory data from the world's biggest hoarders (the US) make price signals meaningless in my view.

Bonds? Again, my preference for clipping coupons is second to none, but I can't ignore the fact that titanic amounts of supply continue to be taken down, just as central banks drop heavy hints about quantitative easing and pessimistic analysts (and well-known investors) warn of inflation holocausts. The mixed messages tell me that the current "steepness" of interest rate curves in the developed markets can't be trusted.

Credit? Again, the few investment banks that remain on the market-making landscape have had their balance sheets so eroded they're not able to defend "bid-to-offer" price spreads in any meaningful way. This causes huge dislocations in corporate bond spreads as big investors push prices lower and then pile into longer-term positions.

I understand the emotions that lead to capital preservation trades, but I also adhere to the taxi-driver theory of investment: if my cabbie thinks it's hot, it's time to go the other way. High-yield bond fund-flows have risen nine weeks in a row, according to AMG Data Services, much of it from retail-driven ETFS. This simply doesn't square with the 22 percent year-to-date dip for the S&P 500.


The unpalatable truth is that equity markets seem the purest measure of investor confidence, corporate health and economic prediction.

In his monthly newsletter, PIMCO's Bill Gross outlined the simple fact that the destruction of the "shadow banking system" and its credit-creating structures would mean returning to nominal GDP levels we last saw in six years ago. Essentially, if governments can't replace that lost credit, we're looking at the US economy contracting at 10 percent a year while unemployment soars and asset prices further dislocate.

The knock-on affect to stocks is self-evident: even with the worst quarterly earnings season in history behind us, Thomson-Reuters analysts still expect an overall earnings-per-share of around $63 for the S&P 500: a 30 percent drop from the $88.18 recorded at the 2006 peak.

And don't think stocks haven't suffered from their own form of deleveraging, either: NYSE margin debt levels hit $177 billion in January – well off their July peak of $240 billion.

So, we haven't found the bottom, clearly. But, we're going to see earnings growth of around 21.3 percent this year, simply because the banks have taken so much pain already and won't be the 750 percent drag on the top line number they were in 2008.

Secondly, savvy observers of history who aren't encumbered by political bias will remember that former President Ronald Reagan's first-term team spent more than any other administration since the Second World War. That stimulus dragged the US economy out of the late-70s doldrums and sowed the seeds for the sustained equity market boom that followed in the 1980s.

We're not there yet: there's still skepticism of President Obama's and Secretary Geithner's stewardship to date, the collective 4.9 percent of GDP they're planning to spend and whether or not governments around the world (save China) will respond in kind.

But, at the very least, the equity markets seem to reflect those concerns, and many, many others, in a way that we can all understand.

Perhaps the crowds aren't so mad or deluded after all?