Why Bernanke's Remarks Are Bullish for the Markets - 07/22/10

He is typically among the last to recognize a problem (e.g., the subprime crisis).

By the time he has, the markets are already in the advanced stages of accepting it.

Rearview observations are often irrelevant in predicting future prices.

 

Day after day
Alone on a hill
The man with the foolish grin
Is keeping perfectly still

But nobody wants to know him
They can see that he's just a fool
And he never gives an answer

But the fool on the hill
Sees the sun going down
And the eyes in his head
See the world spinning 'round.

-- The Beatles, Fool on the Hill

Cue audio and cue Paul McCartney's "Fool on the Hill."

Yes, Chairman Bernanke might have been the fool on the hill in his hawkish and inconsistent testimony yesterday, as he pushed back the thought of stimulus while at the same time saying that economic uncertainty was growing. Equally surprising was that he said that the Fed had not completed a review of their alternative stimulus options.

In a perverse way, though, his economic warnings are bullish for the market, as he is typically among the last to recognize a problem (e.g., the subprime crisis). By the time he has, as he did with yesterday's recognition that "it is different this time," the markets are already in the advanced stages of accepting it.

Markets are a discounting mechanism. Rearview observations and, at times, observations regarding current circumstances/fundamentals (especially at important turning points such as the time of the stock market's generational bottom in March 2009) are often irrelevant in predicting future prices.

This was the core of my argument on CNBC's "Fast Money" last night, especially in my debate with my friend/buddy/pal, Brian Kelley.

As I argued last night, the forward P/E for the S&P 500 (on a realistic corporate profits estimate) is now under 12x vs. an average over the past three decades of 15.5x and about 17x when inflation and interest rates are quiescent (as they are now).

Yes, the upside to stocks is capped -- I am using only 13x to get to my 1,150-1,160 S&P target -- by the ambiguity of the current soft economic patch and by the emergence of several nontraditional headwinds (higher marginal tax rates, costly regulation, and federal, state and local imbalances). But the wide gap between historic multiples and today's valuation seems to argue that the concerns are known and discounted.

The downside to stocks will be supported -- I am using 11x, which takes the S&P to the 1,025 level -- by the low probability of a double-dip and by growing evidence of a modest and shallow domestic economic expansion that is capable of sustaining itself.

On "Fast Money," I argued that we are in a growth slowdown, which is fairly typical when an inventory cycle matures. Meanwhile, financial conditions appear to be easing. Credit spreads have stopped widening, and liquidity spreads are also improving (hat tip to Mike Darda!):

  • Two-year swap spreads, which typically presage a lower VIX and better corporate spreads, have narrowed since May.
  • The Bloomberg Financial Conditions Index, which leads GDP by a quarter or so, is improving and, according to the lynx-eyed Mike Darda, is consistent with 2.5% real GDP growth.
  • The euro is ripping higher.
  • Three-month Libor has been flat to slightly down since May.
  • Europe's economic plight might be overstated. For example, as I recently noted, Spanish bonds have risen while the S&P has swooned.
  • Junk bond yields have dropped.

Home, home on the range
When seldom is heard a discouraging word
And the skies are not cloudy all day.

-- Roy Rogers, "Home on the Range"

While I continue to see us in a Roy Rogers Market and a home on the range between 11x and 13x estimated 2011 S&P profits (1,025 to 1,150), there is risk to the upside of my stock market forecast for several reasons:

  • Neither Bernanke's nor investors' expectations are elevated (as they were six months ago).
  • Retail investors are underinvested and have not committed to domestic equity funds. Hedge funds have de-risked and are generally inactive. Who is left to sell?
  • Should bonds begin to drop in price (rise in yield), a massive reallocation out of fixed income into equities could be triggered.

Let's go to the tapes!

My message?

Man up, investors! The economic news has now been discounted in the markets. Chairman Bernanke told us so yesterday.

Well on the way
Head in a cloud
The man of a thousand voices
Talking perfectly loud

But nobody ever hears him
Or the sound he appears to make
And he never seems to notice.

But the fool on the hill
Sees the sun going down
And the eyes in his head
See the world spinning 'round.