Stocks traded to new record highs last week on the back of new central bank initiatives to prop up struggling economies around the world. The People's Bank of China announced an unexpected cut in its benchmark lending and deposit rates for the first time since 2012. Hours later, ECB President Mario Draghi made another promise that his central bank would take new steps to bolster European growth and the ECB announced that it had begun buying back asset-backed securities.
Coming two weeks after the Bank of Japan and Japan's large public pension fund announced manic interventions into financial markets to support that country's failing economy, investors have dismissed any concerns that the end of QE in the U.S. will deny them the liquidity they have feasted on for the last few years. Since the October flash sell-off, markets have gone parabolic and totally disconnected from the struggling economies that are supposed to support them.
The world has things backwards and when it straightens itself out, there will be blood…
One Area of Market Weakness
Last week, the Dow Jones Industrial Average rose by 175 points or 1% to close at a record 17,810.06 while the S&P 500 jumped 24 points or 1.2% to a record close of 2,063.50. Both indices are up roughly 13% from their October 15 low in a mere five weeks. The Nasdaq Composite Index added 24 points or 0.5% to end the week at 4712.97 while the small cap Russell 2000 finished unchanged at 1172.52. The Russell has outperformed larger stocks since mid-October. In the bond market, rates remain low with the yield on the benchmark 10-year Treasury ending the week at 2.32%.
The only notable market weakness in the U.S. has been the high yield bond market where spreads and yields have widened about 30 basis points in November, most notably in the lowest rated names. While there are no immediate large credit problems stalking the market other than the Caesars Entertainment Corp. mess, there appears to be a buyer's strike among the investors who traffic in these types of bonds as they reduce risk at the end of what has been a difficult year for many of them.
"The future is now…"
With stock markets running far ahead of economic growth, investors should be asking whether the markets are getting ahead of themselves. Of course, they were asking the same question a year ago as well. And for much of 2014, it appeared that 2013's spectacular returns had borrowed from the future. But the recent run suggests that as long as central banks keep printing money, the future is now.
Goldman Sachs hit a cautious note, however, in its market forecast for 2015 with a 2100 year-end target that we might hit before the end of this year at the rate we are going. A major Wall Street firm calling for only a 5% rise in stocks next year should raise serious questions since these firms are paid to be bullish. It appears that Goldman, a firm that can't be easily fooled, is trying to warn investors without coming right out and saying it that things are not as wonderful as they seem on the surface. Goldman actually expects the market multiple to drop slightly to 16x, again an extremely unusual call for a major Wall Street firm in the business of dishing out pure hogwash.
It also expects ten-year rates to rise to 3% in the U.S., 0.80% in Japan and 1.25% in Germany. While this forecast would still leave rates low in absolute terms and do little to upset markets, they would signal very large percentage moves of 30% in the U.S., 60% in Japan and 50% in Germany that could inflict serious harm on traders (especially leveraged ones). On the other hand, rising rates will handsomely reward investors who are properly positioned for them (as they should be – with rates at such record lows only a global depression would make shorting bonds a dangerous trade today). Finally, Goldman calls for the Euro to drop to $1.15 and the Yen to drop to 130. While all forecasts are best served with salt, Goldman's forecast has a great deal to say about the fragile state of markets if one reads it correctly.
All the World's Dealmaking
The other thing driving markets higher is a record volume of M&A transactions that have now hit more than $3 trillion in 2014. Many observers view M&A as a sign of confidence in the economy. I tend to view them more of a sign that corporate executives are finding a dearth of organic growth in their businesses. Further, mergers tend to result in cost savings in the form of layoffs and other efficiencies that subtract rather than add to economic growth. Nonetheless, they unquestionably lead to short-term stock gains so the market (and financial media) celebrates them. Last week, we saw two megadeals announced.
In a massive deal in the oil services industry, Halliburton agreed to acquire Baker-Hughes Inc.in a $34.6 billion deal. The purchase price is $78.62 per share, a 31.3% premium to BHI's closing price of $59.89 before the deal was disclosed. HAL was threatening to go hostile if BHI did not agree to the merger. As the Houston Chronicle wrote, BHI was facing "a tough choice: surrender control on a rival's terms or face months of sunken oil prices and cost pressures alone…
Halliburton's demands come as crude oil prices have fallen dramatically and as the U.S. oil industry looks to an uncertain future. Much is unclear: how much producers will rein in equipment and service spending, whether oil prices will sink or swim, and how much Baker Hughes would be worth in six months after what would likely be a bruising battle for control of its board." On a pro forma basis, the combined companies had 2013 revenues of $51.8 billion, more than 136,000 employees and operations in more than 80 countries around the world. BHI was trading at 20x earnings before the deal was announced so HAL is paying a high price for its rival. No doubt many of those employees will lose their jobs since the companies expect to realize $2 billion in annual cost savings.
No Moral or Legal Niceties
In a second megadeal in the pharmaceutical industry, Actavis plc (NYSE: ACT) agreed to buy Botox maker Allergan Inc. (NYSE: AGN) for about $66 billion. The purchase price is $219 per share, 10% above AGN's closing price on the day before deal was announced although the offer was widely rumored.
Allergan turned to Actavis to ward off a hostile bid from Valeant Pharmaceuticals Intl. Inc. (NYSE: VRX) and hedge fund activist Bill Ackman. Valeant and Mr. Ackman's fund will end up with more than a $2 billion profit on their investment – and lingering questions about whether they violated insider trading laws – but all their investors will care about is that they made money. Remember: we are in a bull market where moral and legal niceties are ignored.
They Fought the Fed and the Fed Won
Markets appear hell-bent on rallying through the end of the year as active managers desperately try to dress up another year of underperformance. Goldman Sachs points out that the average hedge fund index is -1% for the year compared to +13% for the S&P 500 and +11% for the average large-cap mutual fund (and with much higher fees obviously) largely due to the "smart money" having serious doubts about economic growth and corporate earnings.
Put another way, hedge funds have chosen to fight the Fed and they have lost. This is true of other active managers in strategies that are supposed to make money when the market rises. Now everyone is chasing performance heading into year end and this is contributing to the market's rise. Like the reaction to desperate moves by central bankers, this performance-chasing has nothing to do with fundamentals and could end badly in January.
A Dangerously News-Driven Market
The question remains when markets will begin to pay attention on a sustained basis to anything other than monetary policy. There is a political showdown shaping up in Washington, D.C. in the lame-duck session of Congress now that President Obama has moved ahead unilaterally on immigration.
Political gridlock could lead to a government shutdown or other signs of political paralysis that make it clear to the market that there will likely be no movement on important issues like tax reform or fixing Obamacare over the next two years. Markets may be willing to live with bad government as long as they keep rising, but the minute they falter they will start screaming for effective leadership. For the moment, however, it appears that investors are focused on dressing up their performance for year-end and accepting the gifts being given to them by increasingly desperate central bankers. As T.S. Eliot famously wrote, we live in an era of hollow men.
Editor's Note: Michael Lewitt publishes the highly regarded The Credit Strategist , and was recognized by the Financial Times for forecasting both the financial crisis of 2008, and also the credit crisis of 2001-2002. His 2010 book, The Death of Capital: How Creative Policy Can Restore Stability (John Wiley & Sons) was included in the curriculum at the University of Michigan and Brandeis University.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.