At Ockham, we have been in awe of the continued rally into what appears to be a short term overbought condition despite what would normally be bad economic news. From a market valuation analysis perspective, coming into March we believed the market was due to rebound as the broad stock market was at multi-decade lows for price-to-peak earnings multiples as well as extremely low sentiment. But this V-shaped market surge has taken on a life of its own, and investors seems to have taken on an “irrational exuberance” to borrow the term coined by Alan Greenspan.
There is no doubt that “green shoots” are visible in the economy as jobless claims appear to have peaked and credit spreads have narrowed, but this morning was yet another example of the market brushing aside what would be considered very distressing news about Bank of America (BAC). The government’s stress test results suggest that the company will need to raise $34 billion in capital in order to sustain any downturn in the economy; however, BofA was up about 17%, much better than those that were told they do not need to raise additional capital like JP Morgan (JPM) or American Express (AXP). How can that be rationally explained, insolvency concerns are rewarded more than those that do not have such concerns? The total amount that the government is advocating raising among the 19 banks totals $59 billion.
There was an excellent piece in the U.K. Telegraph by Edward Hadas that makes the point very succinctly,
“But overall, markets and indicators are diverging. The price of oil has risen from $40 to $53 a barrel since February, but inventories are up and demand is down. US bank shares have risen sharply in spite of leaks that 10 out of 19 of them would fail the government’s not terribly exigent stress tests. Meanwhile, government bond yields are barely moved by deficits that would have been considered tragic a few years ago.There is no doubt that seeing the market rise is a pleasure after experiencing the sell-offs of the last year, and long ago I was instructed “don’t fight the tape,” but healthy skepticism is appropriate. It just appears that the speed of this reversal could make recent gains vulnerable once the euphoria eventually wears off. As we have noted, there are still pitfalls ahead that could ensnare this rally, most notable would be the mounting threat of foreclosures, commercial real estate and consumer credit difficulty stemming from unemployment. The market is forward looking, and what we are seeing is gray clouds hanging over investors starting to lift from extremely low sentiment levels. Investors are willing to take on more risk than in the past few months, but that does not necessarily mean that risk will pay off. Caution is still warranted as the market has risen relentlessly in the last two months, and it would not be a surprise to us to see the market pull back.
Bulls argue that the markets are thinking ahead: oil demand will turn soon and banks will shortly generate decent earnings to offset their losses. As for the deficits, the government can always shut down the money presses before inflation takes hold.
These may be true, but they do not justify the market euphoria…”
Ockham Research Staff