Market Fundamentals Disconnect Evident as Popular Shorts Soar

According to Dialectic Capital Management, LLC; equity markets are not being valued using fundamentals. For example, the acceleration in the S&P 500 (INDEXSP:.INX) for the last six months in light of worse than expected economic news diverges from the trend that the S&P 500 gains as economic surprises are positive.

Market Fundamentals Disconnect Evident as Popular Shorts Soar

Source: Bloomberg

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Short Stocks Preceded Market Corrections

Dialectic also notes that shorted stocks have been outperforming recently despite negative earnings announcements and deteriorating guidance. Morgan Stanley (NYSE:MS) noted that outperformance by short stocks preceded market corrections in the last 3 instances.

PIMCO’s Bill Gross argues that central banks worldwide, particularly the U.S. Federal Reserve and the Japanese central bank, have been keeping risk free rates artificially low by injecting money into the economy. The “carry” – a credit risk or equity risk premium that involves a potential gain or loss of principal for an investor above the risk free rate – in financial assets such as stocks and bonds is at historically low levels. This in turn has artificially inflated asset prices. While quantitative easing and near zero interest rates have helped stabilize the real economy during the financial crisis five years ago, the policies have not driven real economic growth through investment and consumption as a result of increasing asset prices. Instead, investors are not been paid enough for undertaking risk. For example, a typical B/BB rated company is able to issue debt at well below 5 percent, which is not enough compensation for an investor to take risk. Investors are in fact being undercompensated for taking risk in high carry assets such as high yield bonds.

Liquidity In Financial Market Needed By “Zombie” Corporations

Furthermore, Gross notes that “carry” is the engine for a healthy capitalistic system.  If investors are not willing to risk capital to earn more than the risk free rate, the capitalistic economy may be in danger. Banks and insurance companies may not be able to support their business infrastructure, as they may not make enough to pay for technology, employees, and real estate for their offices. Lending will be done at a slower place as the deposit base shrinks due to lower net interest margins. Savers’ income is also hampered by low interest rates, and as a result consumption and economic growth potential is limited. Corporations are reluctant to invest in their business and generate real economic growth; instead they choose to return profits to shareholders in the form of share buybacks or dividends. Finally, “Zombie” corporations, those that would not be able to survive without the extra liquidity currently available in financial markets, continue to take up resources that could be put to more effective use by other companies.

Overall, low carry and future low expected returns are hampering real economic growth. When additional liquidity in the system does not promote real investment and consumption but instead discourages it, easy monetary policies may be part of the problem, not the solution. In this environment, Bill Gross is cautious about risk assets such as high yield bonds and equities and recommends a more conservative investment stance.