Rallying markets deliver immediate gains -- but if you're not careful, they also sow the seeds of future losses. At least one well-known Wall Street observer, however, appears oblivious to that basic tenet. If you follow his thinking, you could be in for a world of hurt.
Hot tip?
In a recent Forbes issue, columnist and money manager Lazlo Birinyi, Jr. penned a provocative article entitled "Embrace the Bull." I rolled with Birinyi's decidedly upbeat take for several paragraphs -- until I hit a wall:
Pessimists say that economic growth will be tepid and slow. Somebody forgot to tell that to investors in cyclical stocks such as U.S. Steel (NYSE: X ) , 3M (NYSE: MMM ) and Ingersoll Rand (NYSE: IR ) , which have gained 50% in a matter of weeks -- anticipating a strong recovery.
Read that passage carefully, Fools. Mr. Birinyi repudiates "pessimists'" analysis of the economy by citing the performance of stocks. Look, I acknowledge that the economy and the stock market are linked by a feedback loop, with the performance of one frequently affecting the health of the other. But equating rising stock prices with a positive change in economic fundamentals not only defies basic reasoning, but also encourages hope-based investing.
Through such rosy goggles, we could all cheer an imminent housing recovery in every spike in the shares of Freddie Mac (NYSE: FRE ) . After all, what Mr. Market anticipates surely becomes reality. Regarding better-than-expected second-quarter earnings, Mr. Birinyi -- undeterred by the constraints of logic -- writes, "As holders of Goldman Sachs (NYSE: GS ) , Intel (NYSE: INTC ) , and Caterpillar (NYSE: CAT ) would testify, earnings have been pretty good."
Let's take a closer look at machinery-maker Caterpillar. Its reported earnings per share for the second quarter came in at $0.60, down from $1.14 in the year-ago period. However, lower costs and an inventory benefit together contributed $0.61 to EPS. Additional EPS benefits came from a dramatically lower tax rate and forex tailwinds. In other words, any positive signs amid the earnings bore little relation the health of the underlying business.
But hey, when you allege that market action represents economic reality, why bother with earnings quality?
A hard rain
As 2008 taught us, sooner or later economic fundamentals will catch up to stock valuations. But investors have already forgotten last year's lessons. Seven months into a broad rally, it's just too easy to attribute more predictive power to the market than common sense would dictate.
That's true for professionals and amateurs alike -- which may explain why no one's ever complained that it's hard to lose money in stocks.
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