These days, there seems to be a proclivity towards hot money flowing into financial markets. Though I do not have the statistics, ever since the .com boom America has had a speculative tendency that needs to be balanced against realities. My view is that speculation is good and it is necessary for markets to function. However, when there is too much speculation markets tend to become dis functional. The hope is that when markets decline, unsuccessful speculators are forced out creating a better investing balance. This process has not functioned as efficiently as in past economic cycles.
The hot money is coming from Quantitative Easing Part II (QEII). The Fed is attempting to keep the US economy from falling into a deflationary spiral through a massive bond purchasing program, yet the most immediate outcome is a rise in stock prices and increased derivative activity. This is not a good sign leading into 2011.
For a long time I have been writing about the price to earnings ratio, which remains one of the best indicators of over valuation for stocks. Folks keep maintaining that the US economy is moving into a new stage where P/E ratios are less relevant. I am not in this camp. P/E is still meaningful along with many other statistics.
The following blog post from earlier this year puts forth my opinions about the P/E ratio.
Alan Abelson's most recent article in Barron's is especially perceptive at raising the question of over valuation going into 2011.
Abelson, Alan, 2010. 'Tis the season to be wary. Baron's, Dec. 24.
He writes:
"Moreover, at 20 times this fading year's earnings, stocks hardly stack up as outrageously cheap. On that score, the latest calculation by Andrew Smithers, the smart Brit who runs the eponymous London-based investment firm Smithers & Co., is that U.S. equities are more than 70% overpriced, according to q, his favorite yardstick and essentially a measure based on replacement value."
The next paragraph from Abelson's article raises the prospect that current stock valuations are near historic highs:
"Just to put you at ease, we haven't quite lost our minds, nor Andrew his. The market, rest assured, isn't about to vanish into the void. And Andrew is quick to point out that by his reckoning, stocks are well below their valuation peaks of 1929 and 1999, but more or less even-steven with the highs of 1906, 1937 and 1968."
Of course during the Great Depression, 1937 was important year because the economy fell back from the recovery that began around 1933 thus extending a great deal of misery (see 1937).
With all of the money flowing into the U.S. economy from QEII, I do not think there will be a severe double dip recession in 2011. However, growth will be low and unemployment will remain high.
The big thing to watch in 2011 is level of speculative forces driving markets of all types. These forces seem strong and refuse to withdraw as the following three paragraphs from Abelson's article indicate:
"What we find especially disturbing, in any case, is the quickening of the speculative pulse, paced by wildly leveraging hedge funds."
"As Zero Hedge observes, margin debt on the Big Board in October swelled to $269 billion, a leap of $13 billion over the September figure, and the highest since September 2008, just before Lehman gave up the ghost."
"Any forced unwind, triggered by an unpleasant surprise (yes, Virginia, no matter what your daddy and mommy tell you, there are such things as unpleasant surprises in the stock market) could be very, very ugly."
In spite of a punishing recession, the American financial system continues to be venerable to excessive speculation. This is worry some. One of the unfavorable consequences of government (the Fed) intervention into markets is the possibility of supporting unreasonable speculation. It is hard to know where this will end.
Rather than speculation using cheap money, investors need to focus on start-ups that create genuine value. I very much believe that the path out of what appears to be a structural low-growth mode for the US economy is the creation of new businesses. This will take time.
I do not know what will happen that will focus investors away from excessive speculation toward tangible value.
No comments:
Post a Comment