Authored by Lance Roberts via RealInvestmentAdvice.com,

Over the past couple of weeks, markets haven’t paid much attention to the economic or earnings data but have drifted from one “stimulus” headline to the next.

You get the idea. The daily swings of the market have made it tough to navigate. However, as discussed Monday in our “3-Minutes” video, indicators were already suggesting price action would be weak.

Such was the case as stock prices drifted lower on the daily disappointment of failed stimulus talks.

Deal Or No Deal

The lack of stimulus is NOT surprising. As we stated on the #RealInvestmentShow many times, there is “no incentive” for either side to pass “stimulus” before the election. If the stimulus passes, President Trump will get credit for providing aid to the American people. Such a “feather in the cap” would be something the Democrats are unwilling to provide.

Zerohedge came to the same conclusion on Friday:

“House Speaker Nancy Pelosi told MSNBC a stimulus bill ‘can be passed before the Nov. 3 election if President Trump cooperates.’ However, hedging that statement, she stated that Trump has been ‘back and forth’ on a deal. She also added that Trump needs to get Senate Republicans to back any agreement. 

In response, the White House immediately countered with Press Secretary McEnany saying Pelosi is making it harder by not budging ‘even one inch’ on her stimulus demands.”

The market read between the lines and realized no “deal” is coming. While the markets were hammered initially, traders bid shares up on “hope” stimulus is still coming. The good news is that while the market remains in a downtrend, it continues to hold support at the 20-dma and 50-dma cross.

Market Back To Excess Optimism

What is most fascinating is that while Congress and the media are complaining about how the economy needs more stimulus, the market doesn’t agree. Despite the fact, there has been no stimulus passed, retail stores and the housing market have posted record sales. Restaurants are getting customers back, and credit card spending has picked up sharply from the lows, and, in Houston, traffic has returned.

The market is also picking up on the “recovery,” bifurcated as it may be, as stock market speculation has now surged back to records in both record low short-interest and options contracts.

As I noted on Tuesday in “Bulls Are All In, Again,” 

“Fed actions shifted the ‘risk appetite’ of investors through ‘perceived’ insurance against losses. As we head into a potentially contentious election, market ‘bulls’ are ‘all in’ again as hopes remain high that more ‘stimulus’ will soon come.

Since the Fed intervened in March, investor sentiment has gotten run back up to extremes despite the economy remaining amid a deep recession.”

I also pointed out that professional asset managers are also back to being fully long in portfolios.

“One of the sub-components of the ‘Fear/Greed’ gauge is the NAAIM index of professional investors, which measures the percentage allocation to that group’s equities. Currently, equity allocations of professional investors are back to full weightings. While such doesn’t mean the markets are about to crash, more often than not, their ‘bullishness’ has tended to be an excellent short-term ‘contrarian’  indicator.”

However, while the stock market is wildly bullish, there is a clear disconnect with the economic recovery, such as it may be.

The Great Disconnect

There is currently a “Great Divide” between a “recessionary” economy and a surging bull market in stocks. Given the relationship between the two, they both can’t be right.

The economy, earnings, and asset prices over time are highly correlated, as shown by the chart below.

Since 1947, earnings per share have grown at 6.21% annually, while the economy expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role consumer spending has in the GDP equation. 

The correlation between the two is shown in the chart below.

The current “negative correlation” is quite an anomaly given that corporate earnings are derived from economic activity. However, that relationship broke due to the massive amount of Federal Reserve interventions in the financial markets. Currently, the Fed owns the largest amount of the Treasury Bond market in history.

As shown above, the liquidity flowed into the most highly liquid equities (mega-caps.) Such led to a massive distortion in the markets between the vast majority of index constituents and a handful of mega-cap companies.

That distortion of the financial markets by the Federal Reserve has created an illusion that the stock market, which should represent the economy, is doing exceedingly well when it reality it isn’t.

Bull Now, Bear Later

The is no arguing the market is bullishly biased in the short-term. However, in the longer-term, slower economic growth rates will eventually impact companies’ ability to generate higher profit margins. Such will especially be the case in the event of Biden victory and higher tax rates.

Valuations remain problematic on many levels, but the distortion of the markets to the economy is most prevalent in the market capitalization to GDP ratio.

More importantly, the deviation of the market from long-term means remains extreme. With the markets overbought, extended, and, as noted above, extremely optimistic about the near-term future, the risk of a bigger correction remains elevated.

While the Federal Reserve, through its interventions, quickly abated the previous decline by not allowing for a reversion to occur, the risk of a secondary reversion remains.

In particular, pay attention to interest rates. The recent rise in interest rates, on the assumption of more stimulus leading to an inflationary impulse, has a long history of not playing well with equity markets. Higher interest rates undermine the market’s mantra of overpaying for assets on an equivalent yield basis.

As stated last week, “risk happens fast,” which is why we continue to encourage you to focus on your overall exposures.



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