The market is irrational as ever, but the kernel of truth can't be overlooked
And so the contagion in Europe is finally reaching the American heartland. As I kept telling people this past year, the US market is the only game in town. True, the returns have been lackluster, but going from 1100 to 1200 and then back to 1100 is nothing to blush about. Compare that with the bloodbath taken by the grass-is-greener crowd in markets like China and now in Europe. China is down 25%, and the Euro is rapidly going down toward the purchasing power parity (around 1.20) and looks set to drop much further. Suddenly, my 90 cent target for the Euro looks within reach.
Only the goldbugs have been spared the carnage, but they too will pay the price for their stupidity one day when people realize that gold is not edible and not drinkable either. At $100 an ounce I will return to that issue once again and ask myself if it's worthwhile to purchase some gold for speculation purposes.
What are the reasons S&P is holding up so much better than Europe? First, it's holding up better because it was less overvalued. It was (and is still) in a mini-bubble but not in a dramatic bubble. In contrast, Europe was is a dramatic bubble, if only because the currency was selling for 30% more than it was worth. So we American supremacists (to borrow AndreyLikesMTL's definition) had a smaller height to fall from.
Second, it's holding up better because Europe and China are holding up worse. In warfare, you don't have to walk upright to collect the spoils from a dead enemy. It will be more than enough if your enemy is lying dead on the battlefield and you can still crawl on your knees; the army that's crawling on their knees after the battle will soon become more powerful than it ever was before the battle because they are now in control of the land. And economic warfare is not different. The crash of Europe is making America stronger despite the short-term pain from the lost exports. When the crisis reaches its bottom, American banks will buy Europe and the price will be extremely favorable to them.
The way the "victory factor" works is two-fold. Multiples expand because you want to pay a higher multiple to own a winner than to own some pathetic loser. And the capital that wants to pay this higher multiple also expands because the losers - Europeans, Asians, and I guess, some Americans foolish enough to invest abroad - see the butcher's knife over the heads, take their remaining money, and fly to safety. More money going to US treasuries means more money for the US government to re-inflate its bubbles and less money for foreign governments to re-inflate theirs. More money to re-inflate the US bubbles means more consumption in the US and less consumption abroad. More consumption in the US means more foreign investment going to the US because that's where the consumers are. A virtuous circle starts at home, that is also a very vicious circle for Europe. America becomes richer because it's rich. Everybody else becomes poorer because they are poor.
Third, it's holding up better because of the perception that it deserves to hold up better. The debt situation in Europe is on the agenda, thanks to the valuable insights of the three credit ratings agencies. In capital markets, appearance becomes the new reality. These credit ratings agencies won't ever mention that the debt situation at home is exactly the same as in Greece and since they won't mention it, the reality of the defaulting US government will not become the "real reality" while the reality of defaulting Greece will, because it's in the headlines. All of that explains why I became increasingly bearish on foreign markets last year and then went on record calling a purchase of these stocks one of the worst investing mistakes you can make in 2010. It was obvious that out of the two bubbles - the American and the European - the one that fails to control perceptions will also be the one that pops first, and the one that fails to control ratings agencies will be the one that fails to control perceptions. But that doesn't mean S&P will give you a smooth ride in the short term.
For one, much of the income of S&P companies is made abroad. Yes, the crisis will open up some fabulous opportunities for these companies, but the profit from these opportunities will materialize in five years, and the hits to the earnings will materialize next quarter. We need to go down first in order to up.
Then there will be some losses to the US banks like JPM that have exposure to foreign debt. Again, these banks will end up taking over Portugal, Italy, Greece and Spain, but that will be a little later while the losses or at least the fear of losses will have to be suffered here and now.
Then there will be emotional stress, there will be momentum, there will be Elliott Wave charts and all the thousand reasons why we should go down. Tea leaves reading will point to a bear market and bird entrails will indicate Wave 3 of Wave III of wave iii of wave 3) of wave iii) of wave Three, and all these waves will be peaking at 1100 and cascading down to 500. And all the mo-mo investors will be looking at these waves and hitting the sell button, getting rid of the ridiculous jokes like XOM but also of the reliable, profitable companies like WMT.
All of that would not be sufficient to make a dent in the market if it were reasonably valued. But we are still in the stratosphere and extended valuations make us vulnerable to hysterical pullbacks. That's why I think we may have another 10-15% downside from here. But while we go down 15%, foreign markets will be absolutely decimated. To drive the point home, I will predict that at least 50% and possibly 100% of Chinese stocks trading on American exchanges will be bankrupt in the next 5 years.
It is irrational that we are going down on what (to us) is good news. But if we recall that it was also irrational that we got that high then the world will start looking rational again.
And then by the end of the year the re-inflated US economy will begin to reward investors for this short-term inconvenience. In the nominal terms, at least. The real return is a different story, but for the next 6 months we'll have more important things to worry about.