E-piphany

Today’s will be a very short comment, and there will be no column for the next couple of days as I will be traveling on a consulting assignment.

Stocks shot higher overnight, catapulted again by the continuing expectation that Fed quantitative easing will be good for equities. Not only do I wonder at the power of this notion, I am also suspicious of the fact that the movement in the market is out-of-line with the change in the “delta” of the chance of QE2. More-simply put, how many times can the market discount the same program of quantitative easing? Does moving the probability from 0.85 to 0.90, as a reading of the FOMC minutes yesterday might do, really impact the value of the market that much?

The credulity is increasingly disturbing. For all the talk about how investors are fleeing the market, never to return, the market certainly doesn’t behave that way. JP Morgan today reported earnings of $1.01/share compared to expectations of $0.88/share, on revenues of $23.82bln versus $24.28bln estimated. This was taken as good news in the market, but higher earnings on lower revenues? How did that happen? Well, JPM also announced that it decreased loan loss reserves by $1.5bln.

Note that the Morgan isn’t saying that losses on loans fell by $1.5bln, but that they reduced reserves for losses by $1.5bln. When a reserve account is increased, it lowers current earnings; when the reserve account is decreased, it increases current earnings. This is one trick that companies, especially financial companies, use to smooth their earnings. In this case, the $1.5bln decrease in loss reserves adds roughly $0.38/share to earnings.

Now, I don’t know whether the consensus earnings estimates included an expectation that JPM would meaningfully slash loan loss reserves, but it certainly would seem odd to expect that when the delinquency rate on loans is still basically at recorded-history highs (see Chart below).

Delinquencies don't seem to be arguing for lower loan loss reserves, do they?

To be fair, JPM as of noon was roughly unchanged (I am writing early because I have to catch a flight later), so perhaps investors in that particular stock “get it.” But the NASDAQ Bank Index was up 1.1%, and the broader market up 0.9%. Money is still flooding in. This is not a market where investors are predisposed to flee.

And that, of course, is what makes me want to flee. The range of potential outcomes for the economy is still very wide and there are many unanswered questions about European sovereigns and domestic fiscal policy, to mention just two concerns. It isn’t clear to me that QE2 solves all of these problems; indeed, as I have written recently it isn’t clear that QE2 can solve many of them at all. I am not going to completely exit the market, but feel it’s time to cede much of the field to the true believers.