Examining an 'Unnatural' Market

SAN DIEGO – To repeat what I said on "Kudlow & Co." on Thursday night: "It's said you should never argue with a crazy person. I'll add that you should never argue about a crazy market."

And that pretty much describes where we are - in a market that hangs by the thread of oil until it decides the risk of rising oil prices is irrelevant; in a market that hangs by the thread of the latest economic indicator, until it decides that indicator is irrelevant; in a market that one week is enthusiastic about the Fed's likelihood of cutting interest rates and the next week enthusiastic when it looks like a cut is less likely.

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This is a market, as I've written previously, that lacks conviction and will fall in a vacuum on the whiff of something unexpected - like aging Karl Wallenda, the most famous of all high-wire walkers, falling to his death from a skywalk in Puerto Rico when the wind shifted in a direction he hadn't expected.

Is the economy growing or is the economy slowing? (YRC Worldwide (YRCW) , a trucker that should have its fingers on the pulse of the economy, says the latter.) Doesn't really matter because, as of today, the market sees both as good.

Not to worry: All that really matters is "global liquidity," a catch-all to explain the inexplicable.

"Unnatural," is the way market strategist Jeff Saut of Raymond James explains this market in his latest missive. "Markets typically go up, correct by 25 percent, and then re-rally if the are going to trade higher," he writes. "This, ladies and gentlemen, has not been the case recently as the averages have 'unnaturally' vaulted higher without so much as ANY correction."

He further marvels at how the SEC caved in to a New York Stock Exchange petition in mid-October to reduce margin requirements "for an already over-margined hedge fund community. And that 'mysterious surprise' gave the major market indices another leg up (read: re-rally)....Why in the world would one introduce more leverage into an already over-leveraged hedge fund community is a mystery to us!" (And to us!)

What about the value of the market relative to earnings? Everybody says it's cheap. Everybody, that is, but John Hussman, of Hussman Funds, who in his weekly commentary writes that at 18-times earnings the market is into its "third phase" — the phase, he notes, that Richard Russell of Dow Theory Letters says occurs when stocks "spurt skyward on the hopes and expectations of a continuing rosy future ... The low-priced 'cats and dogs' historically make great moves in this third phase."

Adds Hussman: "To anyone who examines more than one or two decades of market history, even a multiple of 18 is very rich by historical measures, and can't be reconciled simply by reference to interest rates or inflation. On closer inspection, of course, valuations are even more hostile. Over the past three years, profit margins have widened to record levels, which have detached P/E ratios from other fundamental measures - such as price/revenue, price/dividend and price/book ratios. The S&P 500 is currently about double its historical norms on those metrics. That isn't a forecast that stocks have to eliminate that valuation gap, but it certainly does suggest that stocks are priced to deliver unsatisfactorily long-term returns from these prices."

There's no shortage of pundits who would disagree, of course. But that, dear readers, is what makes markets - inverted yields, consumer credit, shaky subprime-mortgages, the weak dollar, uncertain housing, financial leverage and complacency, be damned. Minyanville's Todd Harrison put it best in a column here the other day when he wrote, "For every risk, there is an offsetting reward. And those betting on a year-end ramp would be wise to remember that this is a two-way street." Amen, bro'.

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