Wednesday, September 28, 2011

What's Really Driving this Market?

This has been a very frustrating market for managers who pay attention to fundamentals.

Correlation of stock price movements now stand at record highs - nearly 0.9, according to some estimates. This means that the vast majority of stock portfolio returns are currently based on the beta (i.e. volatility) of your stock positions are relative to direction of the markets.

Corporate fundamentals remain reasonably good. Most companies I hear these days are reporting that business trends are favorable. In addition, corporate balance sheets are in very good shape - in fact, one could argue that many companies have too much cash (e.g., Berkshire Hathaway).

Dividend yields on stocks are attractive relative to bonds. Given the large number of well-capitalized companies trading at reasonable valuations and paying a healthy dividend, one would think there would be a rush to stocks.

But that obviously hasn't been the case, because in today's market only one factor seems to matter: government policy.

It has been slowly dawning on me that it could just be that most of the direction of the stock market in the next few weeks will not be driven by earnings or interest rates. Instead, the fate of the eurozone, or the direction of American fiscal policy, will determine returns.

Put another way: if the euro collapses, or if the bailout package is seen as weak or too tepid, the world's stock markets are likely to move sharply lower. On the other hand, a more aggressive move by the major European players could lead to nice stock market gains.

Yesterday, for example, I headed over to the local offices of Merrill Lynch to hear from their health care services analyst. He was accompanied by another Merrill analyst someone whose sole job is to follow Washington politics.

The room was packed. Portfolio managers from all sorts of firms were in attendance: mutual fund managers, institution managers, hedge funds - you name it, they were all there.

However, for nearly an hour, there was only one topic discussed: Washington.

Although initially I was a little frustrated - I was there to hear about stocks - it also became clear most in attendance realized that the opportunity in the health care sector (as well as many other areas) will be dependent not on current company fundamentals, but rather on government reimbursement policies for healthcare.

Here's the way that commentator Dan Greenhaus put it yesterday on the blog Business Insider:

To repeat a story we have been telling for some time now, and repeated last night, market participants serve at the pleasure of policy makers.

While some might argue otherwise, today was yet another example in our opinion... early market gains -- the S&P 500 was up by nearly 3% while the Russell was up by nearly 4.4% - were generated in part by European headlines but so was the late day swoon.

The Financial Times reported in an article titled
Split Opens Over Greek Bailout Terms that as many as seven Euro area countries were looking for larger private sector involvement (PSI) in the second Greek bailout.

You can read the story for yourself but one thing is certain; the financials went from being among the market leaders to, ignoring a last minute rally, the worst performer on the day... Easy come, easy go.