Notes From Underground: Pay No Attention … To the Stock Market Behind the Curtain

There are ideas permeating the financial media that need to be challenged. There is a continuing idea that the present value of the U.S. stock market is stretched based on historical valuations. I will continue to question this assessment FOR HOW DOES AN INVESTOR VALUE FUTURE EARNINGS IN A ZERO INTEREST RATE ENVIRONMENT? Further more, corporate earnings need to be evaluated with consideration for record low borrowing costs and stagnant wages. This week I hope to take a look at the historical percentages of payroll and interest expense and to see where the present numbers fall in relative terms. The markets may well be overvalued on some normal assessment but we are not operating in any sense of “normalcy.” This present financial atmosphere renders so much historical analysis worthless, which is why this year portends to be so volatile.

Even Fed Governor Jeremy Stein noted in his speech last week that current FED and other central banks’ policy of massive intervention in the credit markets was causing some price distortion in high yield corporate debt markets. Just a word of caution on those who see everything through a poorly focused lens. Will stock markets have large selloffs? Most certainly. WHY? Don’t know as of this moment but to say it is because of overstretched valuations based on some questionable overall PE value is difficult to accept. Will there be problems in the U.S. because of sequestration and its impact on growth? Will credit problems in Europe come to the fore again? Also, the high probability of political turmoil in the European Union will certainly cause profit taking. But overvalued, I certainly don’t know how to assess that measure in these anomalous times.

***ECB President Draghi imitated Fred Astaire at his press conference on Thursday and tapped dance his way around many questions.

1. Several times the president was asked about France’s assertion that the EURO was presently overvalued and the ECB needed to set a rate that reflected real economic conditions. Mr. Draghi would not criticize President Hollande but mainly stuck to his script about the G-20 agreeing to allow the market to set rates and was opposed to any type of currency intervention. Also, Draghi reiterated that the present price of the EURO was its long-term average–thus no problem.

2. There were many questions about the ECB‘s acquiescence to the recent Irish debt restructuring as short-term financing was rolled over to long-term bonds with the ECB‘s permission. Mr. Draghi maintained that this was not the ECB‘s decision and had no say.

3. The ECB President maintains that all is good since the July 26 statement about doing all that can be done to preserve the Euro and end the financial fragmentation that was plaguing the European financial system. While things are certainly improved–yield curves and interest rate differentials have certainly stabilized–greater action on competition and labor market reforms have to be undertaken. Draghi boasted about the rapid improvement in the current accounts of Spain and other peripheries, but high unemployment will curtail imports and cause a contraction in trade deficits.

A looming problem for Mr. Draghi is France, for even while unemployment increases the French current account deficit widened in 2012. A Bloomberg story on Friday (Mark Deen and Anchalee Worrachate), “Bemoaning Euro Strength Masks Hollande Export Woes,” points out that over the last decade “… French labor costs up about 19% and Germany’s almost unchanged ….” The article also points out that France’s trade deficit was its second largest on record “… and two-thirds of the shortfall coming from the Euro area.”  This point is of greater significance coming on the heels of a Friday comment by Andrew Bosomworth, a managing director with Pimco.

Bosomworth was maintaining that the EURO would rally because the ECB and the ECOFIN were pushing for INTERNAL DEVALUATION and not getting into the global CURRENCY WAR and pursuing EXTERNAL DEVALUATION. To clarify for my readers: Internal devaluation is austerity budgets coupled with downward pressure on domestic wages. The downward pressure on wages makes a nation’s exports theoretically more competitive, but an appreciating currency can render the impact of wage comprehension null and void. In calling for a Euro appreciation because of the positive effects of INTERNAL DEVALUATION I hope that PIMCO is also shorting the European bank stocks.

In Spain, where NON-PERFORMING LOANS (NPL) are already high, the immediate impact from austerity and wage deflation is going to put more pressure on bank balance sheets. As Bosomworth says in the Bloomberg interview: “One major difference between the euro area and the other major currencies of the world, the dollar, sterling and yen, is that the euro zone is depreciating internally with wages, everybody else is trying to depreciate externally with their exchange rate.” In the theoretical world of unfettered markets that resides in Chicago’s Hyde Park, Pimco’s managing director may be correct. In the real world of Global Macro Finance, Bosomworth needs to get on the yellow brick road.




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7 Responses to “Notes From Underground: Pay No Attention … To the Stock Market Behind the Curtain”

  1. asherz Says:

    The stock market certainly isn’t high on current P/Es and corporate balance sheets. But the markets are a discounting mechanism. The long term pumping of liquidityin a ZIRP era into the economy has had the effect of investors reaching for yield and increasing risk (high yield bond market reflects this as well). The future effect is that sometime in the next two years a severe inflationary pricing especially in commodities will make its unwelcome appearance. Coupled with a slow growing economy to start with, this will result in a higher cost structure with the inability to satisfactorily pass on those costs fully. Stagflation has never been kind to markets (see late 1970’s ). The markets have not begun to process or discount this scenario and the marginal trader is focusing on the next minute, hour or day, averting his eyes from the longer term picture. The termites are in the basement but the house seems to be secure from the outside.

  2. realitythought Says:


    As usual a good article, I agree with you, how in the world do you evaluate things in this monetary environment as well as the ever changing rule of law of the present administration ( what may seem like a good decision now may become a bad decision with the stroke of the pen or a verbal attack). This past week I had two Merrill Lynch wealth management people pitching me based mainly on old metrics, they did not seem to understand my reluctance to accept their analysis. They seemed to think my concern about inflation in the future ( 1-5 years) was not a factor.

    Relative to inflation, just for you to put in your information basket, I own farm and ranch land in different states. For fifty years prices of $3000.00/acre were considered a reasonable price. In the last 3-4 years prices have escalated to approximately $5-6000.00/acre. Then in the fall of last year many transactions near my various properties were in the $10-11,000.00/acre and one unique situation at $20,000.00/acre. My purpose is not to shout about my good fortune, but to let you know of a real life example of how people are running scared and willing to pay what I think are unbelievable prices for hard assets. The same is true for commercial/industrial property I own (not to the same extent but definitely escalating).

    Although I’m not a trader, but a long term investor I appreciate your thoughts.



  3. yra harris Says:

    Sam–thanks for adding to this discussion.It is not necessarily an inflation piece [yet] but just to get a sense of valuation.Farm land is a very good barometer in a world of ethanol,changing food consumption patterns and forced low interest rates—indeed the proverbial perfect storm.The agrarian economy has long been the bellweather of credit and it impact on production and input valuations.Your example puts teeth into Jeremy Stein’s speech from a different perspective.

  4. yra harris Says:

    asherz—nice rebuttal.But i am left to the recent thinking of Jeremy Grantham—you can beat a donkey to try it make it a horse but it may collapse from the beating and just be an exhausted donkey–a 1% economy rather then a 3% economy

  5. silverbug2155 Says:

    Simply a lot of bankrupt worthless paper sloshing around trying to find a place to park itself in something that is not.Gold will be the last money standing when any of them evaporate.

  6. James Says:

    I dont know what it will take to get rid of some the feds power, but we need to do it soon. Too much is at stake for them to have the discretion they have.

  7. avparekh Says:


    With the Fed pumping in so much liquidity and keeping low interesr rates, how real is the risk of hyperinflation in near future and will this quantitative easing ever end?

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