A healthy reality check for stocks

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Business Times - 16 Jun 2011

A healthy reality check for stocks


WHAT a difference six weeks make. It was only at the end of April that the Dow Jones Industrial Average crossed the 12,800 mark, a two-year high and almost 100 per cent up from its post-Lehman Brothers low of 6,500. At the time, there was boundless optimism that the extraordinary measures undertaken by the US Federal Reserve and government to repair the damage from the bursting of the US subprime bubble were working and that the US economy was on a sustainable recovery path.

Since then, things have taken a marked turn for the worse - US unemployment appears to be worsening, manufacturing is stuttering, the real estate market remains mired in debt and consumer confidence is sliding. US officialdom has put on a brave face, asserting that the weak data reflects nothing more than a 'soft patch' instead of an impending double-dip but investors, previously imbued with unshakeable confidence in the recovery, are now not so sure.

Conventional wisdom is that the recent weak data has come as a surprise, hence the Dow's fall to 12,000 now. On the contrary, the signs were there for all to see for many months now - too much earnings optimism, an over-reliance on the Fed's quantitative easing and an over-leveraged Europe that, after one year of posturing, is far from sorting out its debt problems.

Perhaps more troubling is that despite the recent wobble, little appears to have changed. For example, shares of Internet stocks such as LinkedIn and Facebook commanded bloated valuations six weeks ago - and still continue to do so. In LinkedIn's case, despite the stock dropping 20 per cent in the past three weeks, it still sells for 1,100 times historic earnings or 425 times future earnings. The VIX Index, which is the weighted average of the implied volatilities on options on the S&P 500 and thus represents the market's best guess of how volatile prices will be in the future, is still close to a two-year low. Such a reading is often taken to mean that markets are hugely complacent about future conditions, which in turn could signal trouble ahead. Meanwhile, the Europeans are offering a liquidity solution to what is essentially an insolvency problem and reports are that for the US investment banks that were largely responsible for 2008's financial crash, it is now back to business as usual because regulatory reforms in the wake of the crash have been grossly inadequate.

Not only that. There are also indications that Republican politicians are determined to unwind the Dodd-Frank Act which was aimed at making banks more accountable, while banks are furiously lobbying to erode the thrust of the Volcker Rule, which was supposed to restrict banks to only core activities and forbid own-account trading.

Fortunately, the events of the past six weeks have infused some reason into a market that was threatening to run away from its fundamentals. It might have been painful for those caught at the top but there's no denying that the market needed this reality check.

My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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