Top Gun FP Client Note: The Wisdom Of George Soros, Part II

In the two weeks since my last Client Note, stocks have been treading water at support.  The supply and demand for stocks is in equilibrium at the moment.

 

The bulls believe this correction has mostly run its course and represents a buying opportunity.  David Bianco, Bank of America-Merill Lynch’s Chief US Equity Strategist, told CNBC that investors should stay focused on the fundamentals: record earnings and low interest rates.  Michael Santoli’s Mystery Broker, who correctly played the most recent bear and bull markets, issued a “buy alert” two Thursday’s ago.  He believes the market will trade in a range into late Summer or Fall before a year end rally to around 1400 (“The Mystery Broker Speaks Up”, Michael Santoli, Barron’s, June 18).

 

In favor of the bulls are corporate earnings that continue to be superb through May.  Last Tuesday, Federal Express (FDX) reported solid volumes and pricing for its fiscal 4th quarter.  The same day Bed, Bath & Beyond (BBBY) reported a 7% increase in same store sales.  On Thursday, Oracle (ORCL) reported a good quarter with a 19% increase in new software license revenue even though the stock got hit due to a 6% decrease in hardware products revenue.  After the close today, Nike (NKE) reported a blowout quarter with a 12% increase in future orders and 14% increase in revenue.

 

From a valuation standpoint, none of these stocks are overvalued.  Bed, Bath and Beyond and Oracle are at low-teens multiples and FedEx and Nike are in the high-teens.

 

*****

 

I remain bearish because I believe financial markets are on the verge of breaking down. 

 

Why would financial markets break down if corporate earnings are strong and valuations attractive? 

 

Traditional theory contends that financial markets reflect underlying economic reality.  However, my own belief – following George Soros – is that the relationship between financial markets and economic reality is more complicated.  There is “reflexivity” between the two as each influences the other in a dynamic back and forth.  This is even more true as financial markets grow in size in relation to the overall economy.

 

In September 2009, I detailed how the government’s reflation of financial markets had put a floor under the economy (“Top Gun FP Client Note: The Wisdom Of George Soros”, Top Gun FP, September 22, 2009).  Now, the end of QE2 – in conjunction with topping action in the market since February – persuades me that we are about to experience the other side of the coin. 

 

Without the continual injection of new money from the Fed, my guess is that the “risk trade” will reverse itself.  Money will flow out of commodities and emerging markets and into safe havens like the dollar and treasuries.  That will cause deflation in financial markets.  The effects of all the newly created money which reflated asset prices and bolstered bank and consumer balance sheets the last few years will shift into reverse.  With their assets deflating, banks and consumers will cut back on lending and spending.  This decrease in end demand will hit business and cause a contraction in the overall economy.