Bubbling Markets And The Emperor's New Clothes

By Doug Kass at Real Money

But he hasn't got anything on," a little child said.

"Did you ever hear such innocent prattle?" said its father. And one person whispered to another what the child had said, "He hasn't anything on. A child says he hasn't anything on."

"But he hasn't got anything on!" the whole town cried out at last.

-- Hans Christian Andersen, "The Emperor's New Clothes"

Over the weekend the Bank for International Settlements warned that global stock markets and financial conditions might be irrationally detached from underlying economic conditions and called on central banks to abandon policies that have stoked asset price excesses. The BIS argued that markets might be unprepared for a rate rise and implied that investors might be too optimistic in their faith in global central bank policy.

I didn't need the BIS's two bits, as I have argued, and will continue to argue, that this is one of the most forgiving stock markets in history, as equity prices have arguably disconnected from the real economies.

The bullish meme has now morphed from the notion that the domestic economy will reach escape velocity and reaccelerate dramatically into the quarters ahead to the idea that the prospects for the expansion's length has improved.

After an outsized 2.9% drop in first-quarter 2014 real GDP, the promise of robust domestic economic growth has been quickly muted. Last week's economic data has resulted in Wall Street's strategists and economists lowering their growth projections, and the near-10-basis-point weekly drop in the 10-year U.S. note yield seems to confirm the muted economic expectations.

No worries, argue the bulls, because the expansion cycle, though subpar and substantially less robust than previous forecasts and cycles, will make up for a lack of strength with the prospects for durability and sustainability. And not only does the Fed have your back but so do corporations (in the form of aggressive share buybacks and heightened M&A activity).

It is this thesis of modest growth, reasonable dividends, continued share buybacks and eventually productivity enhancing capital expenditures that has been embraced by market participants. So, according to the bullish cabal, barring a black swan or adverse geopolitical event, a recession or any meaningful swoon in stock prices are years away.

The miserable economic and stock market experiences of 2007-2009 are distant and nearly indistinguishable shapes in the rearview mirror today.

As evidence of this, many money managers (e.g., Legg Mason's Bill Miller) who had fallen (badly) have now risen like a phoenix from the ashes and have regained their reputations.

In other words, fear has been driven from Wall Street.

Nevertheless, in its extreme, today's markets, according to the naysayers (who see subpar and unsteady global growth, vulnerable profit margins, disappointing profits ahead and a general detachment of markets from the real economy), are a fairy tale and are more representative of Hans Christian Andersen's, "The Emperor's New Clothes."

In this short tale, two weavers promise an Emperor a new suit of clothes that is invisible to those unfit for their positions, stupid or incompetent. When the Emperor parades before his subjects in his new clothes, a child cries out, "But he isn't wearing anything at all.

Over history the phrase "emperor's new clothes" has become an idiom about logical fallacies -- namely, pluralistic ignorance, which is defined in Krech and Crutchfield's Theory and Problems of Social Psychology as a situation in which "no one believes, but everyone thinks that everyone believes." In the tale, everyone is ignorant as to whether the Emperor has clothes on or not but believes that everyone else is not ignorant.

Sound familiar?

This column originally appeared on Real Money Pro




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