Posted by Joseph Y. Calhoun, III

The blog Zero Hedge is a dark place where there is nothing good happening in the economy and the stock market is manipulated by evil Wall Street forces. They scour investment research for the most dour of forecasts and feed the paranoia of their readers with vague conspiracy theories. It is certainly profitable for the owners of the site but not so much for readers who are still hunkering down waiting for the Great Depression Part II. Today, ZH muses about the correlation between the dollar and the stock market:

Over the past three months it has become clear that one of the traditional staples of the second part of the bear market rally (the one beginning in July of 2009), the near 1.00 correlation between a weak dollar and a strong market, has broken terminally.

And even with the dollar surging as problems in Europe come to the fore, the market, after dipping temporarily in early February, has staged an almost complete comeback, which has left many scratching their heads as to what the cause for this uncorrelated market move may have been. An interesting summation from one of the more prominent economic skeptics, David Rosenberg, provides some answers not only to this question, but why an economy which refuses to improve, can lead to continuous stock gains.

Why were stocks and the dollar inversely correlated in the second half of last year? Frankly, I don’t know and neither does ZH. It can probably be best summed up as correlation happens, but here’s a hypothesis. When the market melted down in the fall of 2008, the dollar rose as the carry trade was unwound and investors sought the safety of T bills. A rising dollar is deflationary which would tend to make the recession worse and reinforce the trends in the stock market. As the Fed commenced quantitative easing in the spring of 2009, the fear of deflation started to ebb and stocks were bid higher. In other words, stocks rose because the economic outlook improved as the dollar fell. Or the Fed and Goldman Sachs were manipulating the stock market and ripping off the public, if you write for ZH.

Eventually a point is reached though where a falling dollar is no longer beneficial but instead becomes a sign of potential future inflation. So naturally, there must come a point, as the recovery takes shape, when the dollar needs to stabilize before inflation expectations get out of hand. We seem to have reached that point around the beginning of this year and as the dollar strengthened, stocks corrected. Why? Well, my guess is that the previous view of falling dollar good/rising dollar bad took some time to change. Traders tend to cling to indicators as long as they work and find others when the previous one fails. Investors, having a longer time horizon and investing on fundamentals, are not as prone to the whipsaw emotions of short term traders and take more time to commit to a market or a stock. So traders were selling because they saw a rising dollar while investors were thinking longer term and buying the dips.

The point is that the correlation of the dollar and stocks is not something that has ever been predictive in the past and is unlikely to be all that useful in the future. ZH latched onto the inverse correlation because it was a simple minded way to view the market that worked in the short term. Now that it has stopped working, ZH needs to find a reason that their view of the markets has been revealed as, well, bullshit. So they go to the uber bear David Rosenberg for an explanation:

We were told at a dinner last night with some clients and prospects that yours truly is far too bearish and that whatever good news there is out there goes under-reported. That was the view by a few. Then there were others who said that they get confused in those precious few times when I do report something positive over whether I am changing my forecast. Yesterday’s pledge to turn optimistic at the earliest opportunity is a case in point on that last point. You can’t win.

 So I am going to say something positive right here and the answer is no, I am not changing my macro or market view, but merely providing some colour on why it is that the equity market refuses to go down even in the face of what has been a slate of disappointing economic news over the course of the past month.

First, dividend payouts are back on the rise. In fact, February was the best month on this score in two years with 47 companies in the S&P 500 boosting dividends or initiating a program; only one company cut. There is more on this file in the USA Today’s business section.

Second, stock buybacks are increasing — up 37% YoY in Q4 according to S&P.

Third, M&A activity is expanding — another sign of business confidence. According to Dealogic, the number of deals in the U.S.A. is up 13% so far this year, to 1,579 (and the dollar value has soared 46% to $144 billion). And the M&A boomlet has gone global with China and India playing a critical role (see Asia Setting Torrid Pace For Mergers on page B1 of the NYT). Half of the deals this year have been of the all-cash variety versus a year ago — and keep in mind that the S&P 500 nonfinancial sector is still sitting on a cash hoard of $932 billion (up 31% from a year ago — see page C1 of the WSJ for more: With Fistfuls of Cash, Firms on Hunt).

If there was an impediment, in addition to a murky economic outlook, it is valuation. There were revisions to the Shiller valuation data and the latest reading on the normalized real P/E multiple is at 20.64x, up from the 20.0x in February and 20.5x in January. The long-run trend is at 16.36x, suggesting that the S&P is currently overvalued by 26%.

So, Rosenberg sees a lot of positive action but refuses to change his outlook on the market or the economy. Um, okay. In other words, he’s been wrong and seems determined to stay that way. I guess being right isn’t part of Mr. Rosenberg’s mandate.

Rosenberg also opines on the non farm payroll report which will be released tomorrow. Administration officials have been prominent in saying that the weather could impact the data. Here’s Rosenberg:

As far as tomorrow’s payroll report is concerned, it may be more of a “clean” report than many are looking for, the reason for this is because the blizzards last month did not occur during the BLS survey period. According to John Crudel at the New York Post, the biggest storms were February 5, 6, 9, 10, 24, 25, and 26. When the BLS conducts its poll of companies, it asks them about the number of employees for the pay period that ended on the 12th day of the month (and the only issue is whether or not the person got paid, not whether they were actually at their desk).

I could be wrong but wouldn’t February 5,6,9 and 10 fall in the pay period that ended on the 12th? Just asking. I have no idea whether the snow affected the payroll report but this comment does nothing to disprove the idea. My guess is that the effect is probably minor. For a worker about to be laid off, the snow may have delayed the inevitable. For a new hire, the snow may have delayed the paperwork process. Maybe its a wash?

The point of all this is that the pessimists will not change their minds about the economy until the evidence is too complete to ignore. If you’ve spent the last year listening to the rants at Zero Hedge you’ve missed one of the greatest buying opportunties of all time. This is a comment from RSDallas in the comments section at ZH:

Somebody help me out there.  OK I have actually agreed w/ Rosenberg and other more bearish analysts throughout the last couple of years.  This has resulted in my portfolio being basically in an all cash position for going on 2 years now.  All I have heard for 2 years now is that this rally is a bear rally, phony, not real, won’t last and is due to crash at anytime.  Well I’m beginning to run out of patience here. 

The reasons to doubt this market advance are very freaking real, but it doesn’t appear that billions of other peoples money agree with this.  I don’t really believe that just “a few” entities can push this market up like it has been pushed up.

At some point in time one has to take a position either long or short.  Does anyone have any thoughts as to how long this phony rally can rally?  If it’s phony it can’t run forever.

Investing is not as easy as identifying all the negative or positive stuff about the economy. If you only buy when all the news is sunny and sell only when the news is all yucky, you are bound to buy at tops and sell at bottoms. Markets offer bargains when things look the darkest and having the courage and the optimism to buy at that point is difficult but that is exactly what good investors do. Here’s what I wrote last March 11th:

We have just come through a period where we had a deflation of asset prices which was much more severe than anything we’ve seen since the Great Depression. All asset classes fell during this period with the exception of government bonds. We have had periods during the last 30 years when that happened but not a period of such intensity or duration. I believe the deflationary episode is now ending and it will become evident over the next few months which asset class will lead us out of this period.

…

In the shorter term, the actions of the Federal Reserve will have a positive effect on economic activity. The recently passed stimulus bill, while very poorly designed, will also have an effect on activity. These coordinated actions will likely show evidence of success soon, especially the Fed actions. This will show up first in higher asset prices and later in the economic statistics. My concern is for the longer term. Neither of these actions can be sustained in the long term and are actually just more of the same policies that got us in this mess to begin with.

Websites like Zero Hedge are entertaining but that doesn’t mean you should run your portfolio based on their view of things. They are trying to attract eyeballs and sober analysis doesn’t compare to conspiracy theories and doomsday economic outlooks in that department. Read it for the entertainment value and get your investment advice elsewhere.