Stock markets disconnected from economy

I yesterday published a short post on Chinese equities and said: “… it looks if more downside is in store for the Shanghai Composite Index and it would not come as a surprise if lower Chinese equities serve as the catalyst for a well-deserved pullback in global stock markets.” With the MSCI World Index, the MSCI Emerging Markets Index and the major US indices coming off the boil yesterday, China may already have started leading world markets lower.

On a number of occasions recently I have asserted that the stock market has become disconnected from the economy. Mohamed El-Erian, CEO and co-CIO of Pimco, yesterday shared this view in an interview with CNBC. He said: “The stock market has gotten way ahead of the reality on the ground.” Arguing that markets are on a “sugar high”, he added: “Stock investors are making overly optimistic assumptions. The key stimulus has already come to the consumer and has helped in the last few months. But for the third and fourth quarters looking ahead, I am not so sure things will be as good.”

Click on the image below to view the interview with El-Erian.

Source: CNBC, August 14, 2009.

The Q2 earnings season came to an end yesterday with Wal-Mart’s report. Although the bulk of the Q2 earnings reports have beaten earnings estimates, the actual level of earnings nevertheless remains depressed. With share prices rallying strongly and earnings still heading lower, valuations have become stretched. Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 25.6. Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2009, reduces the valuation to 18.6 – still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

David Rosenberg (Gluskin Sheff & Associates) commented as follows: “Based on past linkages between earnings trends and the pace of economic activity, believe it or not, the S&P 500 is now de facto discounting a 4.25% real GDP growth rate for the coming year. That is what we would call a V-shaped recovery. While it is possible, though in our opinion a low-odds event, it is doubtful that the economy is going to be better than that. So we have a market that is more than fully priced for a post-recession world – any further gains would suggest we are moving further into the ‘greed’ trade.”

“Obviously, if the current bull is going to have any sustainability at all, earnings will have to start growing again. But for now, as evidenced by the skyrocketing PE ratio, investors are paying up on the hopes of future earnings growth,” remarked Bespoke. “Don’t be surprised if we begin another period of sideways trading now that the most recent earnings season has come to an end. With the Dow down a quick 150 this morning [Friday], it looks like the hangover could be pretty rough.”

Source: Bespoke: August 14, 2009.

As I said before, a much-needed pullback/consolidation of frothy markets looks likely. Be cautious out there!

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