Liquidity-Fueled Rally Explodes Higher

The recession is over, and unsurprisingly, stocks have risen off the bottom.  Hard. 

The S&P 500 is up 71% since it bottomed a year ago almost to the day.  The Russell 2000 is up 94%.

Exactly a year ago, I wrote this;

The median price/earnings ratio of stocks in the Russell 2000 on trailing 12 month earnings closed today at 5.9x.  The median PE on forward earnings for 2009 is 8.0x.

For the Russell 1000, the median trailing PE is 7.6x and the forward PE is 9.3x.

For the Russell 3000, the median trailing PE is 6.6x and the forward PE is 8.6x.

For the S&P 500, the median trailing PE is 8.6x and the forward PE is 9.4x.

Valuations are at generational lows.

The question now is do valuations reach lifetime lows?

The market bottomed a few days later.  It was a generational time to buy. 

Things have changed appreciably since then.  As I noted a few weeks ago, stocks are no longer inexpensive.

In fact, stocks are expensive.  The median forward PE on 2010 operating earnings in the Russell 3000 is 15.5x.  The historical average forward PE on reported earnings is 14x.

Given the propensity of analysts to ignore very real "extraordinary" and re-occurring "nonrecurring" charges, Wall Street tends to over-estimate actual profitability of corporations by 10% to 20%.  Adjusting for charges, the median stock is trading at 17.2x to 19.4x forward earnings, a 23% to 38% premium above historical averages.

Does this matter?

Of course not!  At least not in the near-term.

Stocks are behaving as they normally do off the bottom of a recession - they are going up.  The question is whether or not stocks are properly reflecting the strength, or lack thereof, of the economic recovery.  And the answer is almost certainly no.

For stocks to be long-term buys here - rational buys - the recovery must be much stronger than expected. That is unlikely.  It is likely that the economy will be weak compared to other post-WWII bottoms, given the nature of this recession.

But rationality is irrelevant in the near-term. What matters in the near-term is liquidity, and the world is swimming in it.

Kate Welling had a great interview with Michael Belkin, author of the Belkin Report, in January.  Belkin may have the best explanation for the market's recent behavior. Not only is the economy getting better, Belkin notes, there is also an ocean of liquidity flooding the markets.

[T]he Fed has announced with great fanfare that they're going to end their mortgage buying program of $1.25 trillion at the end of March. ...

So this asset category started at zero and it's now at $919 billion.  Let's do the math.  It's going to buy a total of $1.25 trillion and already owns $919 billion; that leaves $331 billion to go; $331 billion in 11 weeks is $30 billion a week.  So basically, this reminds me very much of the Y2K situation ...

Around Y2K, the Nasdaq doubled in six months before it topped in March 2000.  One does not want to be short if the market is going to replicate what happened when the Fed injected liquidity in response to Y2K.

[T]hey told you ahead of time how much they were expanding credit and ahead of Y2K they implemented a significant percentage expansion of their balance sheet, around 20%, just by buying bills and treasury securities. ...

The buying that the Fed says it's going to be doing between now [mid-January] and the end of March - about $30 billion a week - amounts to a 15% increase in Fed credit.  Fed credit is currently $2.27 trillion, so what the Fed is saying is that it is going to grow that by 15% in the next 11 weeks.  And Fed credit is already running at an 18% three-month annualized growth rate.  So basically, they're saying, on the one hand, that quantitative easing is going to end.  But in the meantime, what's going to happen in the next 11 weeks is one of the largest credit expansions, potentially, on record.  [Emphasis added.]

As it turned out, the Fed balance sheet was $2.28 trillion at the end of last year, and is $2.32 billion today, an increase of 1.8% but an annualized increase of 11.4%.

However, if you look at the composition of the Fed's balance sheet, you see something interesting.  The Fed has been adding to its mortgage book, purchasing $126 billion in MBS and agency debt over the last two months, an annualized increase of 46%. 

Offsetting the expansion in the mortgage book has been the winding down of short-term facilities, particularly the TAF, the commercial paper program and FX swaps to foreign central banks, which have declined $77 billion in total.

The commercial paper and inter-bank markets have been healing for some time, and it is unlikely that much short-term liquidity made its way into long-term risk assets.  Liquidity from buying mortgages, however, is another story.

When the Fed buys securities, it injects cash into the financial system.  Cash that was injected by the Fed into the short-term cash markets was almost certainly used for cash, given the tremendous crunch that occurred in the cash markets.  Cash injected further out the curve is probably being allocated towards other riskier assets.

The average duration of a mortgage is about seven years.  If banks are swapping mortgages for cash, they are redeploying that cash into longer-duration assets, such as stocks and bonds.  As the Fed swaps mortgages for cash, liquidity floods the financial system and banks use that cash to buy stocks and bonds.  When liquidity is being injected into the asset markets at a 46% clip, it is no wonder that stocks go up like a feather in an updraft.  This is the effect of quantitative easing.

Zero Hedge argues that quantitative easing is nearing an end.  However, as Belkin notes

[I]t's going to be difficult for stocks to decline for the next 11 weeks, which is to the end of March.  That's just because of momentum.  It's like when the space shuttle takes off.  Even after they shut the rockets off, there's enough momentum to keep it rising for a while before gravity takes over. 

This explains why markets keep rising even though retail investors continue to withdraw from the market and volumes grow lighter and lighter. 

In fact, with the exceptions of last Thanksgiving and the Christmas period, the past month's rally has been off the lightest volumes since the market bottomed in March.

There has only been a week of trading this month, but if trends continue, March will be the lightest volume month in years.

I think I was wrong a month ago when I said the nature of the market has changed. The market may very well be higher later in the year. 

In the near-term, we are extremely over-bought.  Over the past month, the Russell 2000 has risen 14% while the S&P 500 is up 9.5%.  The RSI on the Russell 2000 is at 74, an extreme level.  When the RSI gets that high, the index usually corrects 5% to 10% over the next few weeks.

But we are living in unusual times.  The monetary and fiscal stimulus injected into the economy and financial markets is unprecedented.  Jim Grant estimates the volume of stimulus is 10x any amount since WWII.  There are no historical references for this amount of liquidity in the markets.  Markets are doing weird things.

We live in a liquidity-driven world, where the authorities are targeting asset prices.  The imbalances are enormous.  It is as if we have hardly learned anything from the financial crisis.

The end game will not be pretty, but the end game may be a while away.

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