Reality v. Hyper-Reality

For several months now the US economy has been steadily softening on the back of a real estate recession, the loss of manufacturing jobs, increased prices for fuel and food and, more recently, a developing stall in retail spending. And yet, stocks are making new highs - what gives?

There are two things happening at once:

1. Individual retail investors are largely absent, at least directly (i.e. outside their pension plans). This leaves the market in the hands of professionals, mostly hedge and private equity funds, i.e. momentum players who amplify existing trends.
   
2. The perceived and highly convenient wisdom among such professionals is that the economy is merely going through a temporary soft spot and will soon bounce back - with a boost from a Fed rate cut, if necessary. Thus, they hang on to stocks because current P/E's at around 18x (S&P 500) are not "expensive". Determined buying comes from M&A and LBO activity (i.e. spending OPM to make huge fees, no matter what the outcome).
   

But... what if the economy is headed towards deeper trouble than expected? What if the combination of (A) high debt + (B) negative saving + (C) lower home prices produces a stubborn consumer spending strike (70% of GDP)? Corporate profits will drop and "low" P/E's will prove very high in retrospect.

What are the chances of this happening? Comparisons with the Depression Era should always be taken with big grains of salt, but it is undeniable that the A+B+C combination has not been seen in the US since... the Great Depression. If the adverse effects of these conditions get established as negative consumer behavior it will be impossible to avoid a stubborn recession.

As a first sign, retail sales are already softening, running at +2-3% vs. last year, i.e. negative when inflation is accounted for (see post from May 11). I believe that such spending is the proverbial canary warning about overall consumer behavior, since cutting down on trips to the mall is the fastest way to achieve immediate savings. In fact, ShopperTrak reports that in April foot traffic at US retailers dropped 13% and sales rose a paltry 2.3% vs. last year. As usual, poor weather is being blamed, but if this persists for several more weeks we could see weakness spreading to other types of non-essential discretionary spending, i.e. services such as lawn care, gyms, car washes, hair and nail salons, etc.

In this respect, I am convinced that momentum players are not properly assessing the rising fundamental risks and are just looking to the market as a guide to the economy. The market's action has thus become disconnected from economic reality, as in "the economy is weak, but the market is up so the economy must be strong". This kind of circular logic is creating a fallacious hyper-reality of wishful self-fulfilment than can readjust suddenly and create a severe market correction.

Let me put it another way: "normal" market extremes are easy to identify because the greater public jumps in with both feet screaming with delight - it is happening in China right now. But the kind of "silent" extreme we are experiencing in US and EU markets right now, is contained within the cerebellums of the professional community and, in my opinion, has zero tolerance for error. If hyper-reality shifts to plain old reality, suddenly EVERYONE in the hedge/private/pension community will become a motivated seller but there will be no willing buyers because the individual investors are long gone and hurting from the popped housing bubble, besides.

Below are some plain "reality" charts:

RETAIL SALES

MFG. GOODS ORDERS

INDUSTRIAL PRODUCTION

DURABLE GOODS ORDERS, EX-AIRCRAFT

NEW HOUSING PERMITS

EMPLOYMENT

As for hyper-reality charts... look at any stock market index you choose. I like this one: The Shanghai SE "B" Index, up 75% in ONE MONTH.

SHANGHAI "B"