As I’ve said at various points in the past two months or so, the state of the economy is not a healthy one; inflation is on the rise and growth is slowing. Normally, conditions like this would lead to a falling market. Apparently, however, the bad inflation number we saw today combined with the nosedive in earnings expectations doesn’t matter to the market because valuations are fine on a forward P/E basis. Frankly, this is a ridiculous line of reasoning because of the uncertainly surrounding future growth. Initial estimates for Q1 2007 growth were above 8%, now they have been more than halved and sit just above 3%. Has the market sold off on this downbeat development? No… with part of the logic being that slower growth might bring about a Federal Reserve interest rate cut.
The flaws in this line of reasoning are tremendous. Expectations of a Federal Reserve rate cut should not be the reason to buy stocks, especially given the number of fundamentally weak companies that seem to have been supported large thanks to the asset-inflation boom. If anything, the reason to put money in stocks comes from the withdrawal of money from short-term bonds, which will likely be hit hard as inflation continues to be a lingering problem that may even be exacerbated by rising food costs in addition to persistently high energy prices. Still, I think that is a very weak reason to generally buy stocks when the majority look overpriced on a free cash flow yield basis. Remember, cash flow, not “forward earnings estimates” or EBITDA, pay the bills for a company. Be selective…
As for the chances of a rate cut, I think the stock market is (again) overpricing the chances of said rate cut actually materializing. The current interest rate futures price in less than a 10% probability a cut will occur by the end of June, which I feel is more or less appropriate, but the market rallying in the face of higher inflation and no sign of a cut is befuddling. The bullish investors here seem to be grasping for any sort of reason to push stocks higher, but that seems to be a generally futile exercise at this point with the circumstances and current elevated valuations. Given the falling dollar and rising inflation, I would say the odds of an increase in rates is higher than a decrease; keep in mind that a falling dollar will also make imports more expensive, which could further drive inflation given the dependency of the American economy on foreign producers. If Bernanke doesn’t take action (i.e. raising interest rates) sooner than later, he could jeopardize both economic stability and his credibility as an inflation fighter.
