Editor's note: Mike O'Rourke is chief market strategist for BTIG. His primary focus is identifying short-term catalysts driving daily trading activity and addressing how they fit into the "big picture." This is his first column for TheStreet.com.
Most market observers are widely familiar with the premise that bubbles are formed in an environment of perfect or near-perfect fundamentals.
In those perfect fundamental environments, the bullish mindset is an easy sell. It makes perfect logical sense. Missing a bull market often appears foolish, and betting against one appears even more foolish. In a world in which fiduciaries are expected to be "prudent," making a decision that contradicts logic (even if only in the short term) is a challenge.
Instead, the fundamental strength of a bull market provides logic behind an investment that makes participating in the frenzy a much easier decision. As the idea is popularized, the upward trend in prices becomes self-validating. Eventually, the frenzy creates a valuation issue in which the prices paid for the asset far outstrip the future fundamental prospects.
The bubble of bearishness that persisted earlier this year climaxed in March. The nationalization calls pumped in the last and largest bursts of air.
Chairman Ben Bernanke's testimony and statements that the large banks would not be shut down were the pin prick that popped the bearishness. This does not imply we're in a new bull market (only time will tell), but we are well into the healing process, and the stage has been set for an improvement in fundamentals going forward.
Crude Bubbles Up
One of the several recent bubbles was in crude oil last year. There was a set of precepts dominating the crude debate, urging the purchase of crude in the face of a weakening global economy. One key theme that was reiterated was that "the world is using 2 million more barrels per day than we were taking out of the ground."
Another was that crude is "a non-renewable finite resource." Lastly, we were repeatedly reminded about the rise of China and other rapidly developing economies, which will certainly be responsible for a larger share of energy consumption going forward. Those true arguments set up a state of near perfect fundamentals.
By contrast, the centerpiece of the bearish thesis was the weakening economy. A year ago, the recession was less apparent to many (although we were already six months into it) and was easily dismissed because of the massive Fed liquidity flowing into the system.
One of the strongest catalysts feeding the move was price momentum. As crude rose effortlessly, it validated the bulls and eroded the credibility of the bears. The price continued to rise until it collapsed on itself. At the same time, the recession gained incredible momentum amid a financial panic, and within six months, crude dropped 75%.
The moves of this cycle were exaggerated as a result of the many historic events unrelated to crude that were unfolding. Because of the credit crisis and recession, not much attention was paid to the energy projects that resulted from crude's rise in price. Without the potential for greater profit resulting from higher prices, these projects would not have been economically feasible. Below is a chart of the price of crude and the
Rotary Rig Count, which is representative of projects coming online.
Of course, new projects resulted in greater supply. The adjustment process of free markets is meant to do exactly that. The market pricing of crude self-corrected the fundamental supply-demand imbalance (at least over the short term of a year). The ensuing onslaught of the financial panic created additional damage to both the price and end-user demand (again, at least in the short term). The "bubble" burst.
Let's shift to the events in the equity market over the past year. There is little doubt that both the economy and financial markets were standing on the edge of the abyss last fall. The government stepped in to backstop the system, but TARP lacked direction and consistency. Instead, it was a roving $700 billion orphan looking for a home and after it was found in the banking, insurance and auto industries (with companies such as
Bank of America
getting a big hand from Uncle Sam), Congress retroactively changed the terms of the deal for participating companies. In doing so, Congress greatly undermined investor confidence.
The economic contraction and financial market weakness continued into the first quarter of this year. Challenges in the market and economy remained and dominated the headlines and chatter. Investors were repeatedly reminded that the U.S. economy is overlevered (which it has been for a very long time), banks are loaded with "toxic assets," and consumers can no longer pay their debts and have no capacity to borrow. Consumers represent approximately 70% of U.S. GDP, and in their near fatally wounded condition, a recovery seems nearly impossible.
With unemployment rising as rapidly as asset prices were falling, deflation became the real risk. The weak economy means reduced demand for crude. The housing industry is in a depression, and inventories continue to rise. If deflation persists, any money borrowed today will be paid back with dollars that are more expensive.
Therefore, borrowing and investing are not attractive options. Without investment, job growth stagnates, and unemployment continues to rise. Just about every policy step that the Federal Reserve and Treasury have taken for two years appeared to be an utter failure.
The list goes on and on, but those are the highlights. The climax of events occurred in late February and early March as Nobel Prize- winning economists and others clamored for (i.e., nearly begged) the Obama administration to nationalize the banking system. The culmination of these events was a perfect storm of awful fundamentals that created a bubble of bearishness.
Certainly, the problems enumerated above are serious and legitimate, but the fundamentals were so bad that the market's self-correcting process accelerated. Let's consider crude again. Earlier we looked at a chart showing rigs coming online as a result of crude's higher prices. Below is the chart extended recently. As the chart shows, all of the projects that came online went off line fairly quickly.
As for housing, although down 15% from its peak, the supply of existing homes remains elevated because of all the foreclosures. But the seeds of recovery are being sown. Consider the level of housing starts, which dropped more than 40% below the previous trough levels over the past half century without taking into account population and household growth during that time period.
New-home builders have dramatically reduced inventory to the lowest level in eight years. Although new-home inventory is not at 40-year trough levels yet, if they continue to drop at the rate that they have been, those levels are on the table. I can certainly envision an environment over the next year where builders may appear to have no supply.
Check back for Part 2 of this overview, featuring banks and financial institutions
Mike O'Rourke is chief market strategist for BTIG, where he advises the firm's clients on market developments and provides them with "Market Intelligence." Mike's primary focus is identifying short-term catalysts driving daily trading activity and addressing how they fit into the "big picture." O'Rourke has 13 years of experience in the financial markets. He started his career on the floor of the New York Stock Exchange with specialist firm Spear, Leeds and Kellogg. At SLK, Mike transitioned to the Nasdaq as market maker trading technology stocks in the late 1990s. In 1998, he joined the Proprietary Trading Group, managing his own portfolio, and thereafter, he traded proprietarily for Goldman Sachs following its acquisition of SLK. In 2003, he joined one of BTIG's predecessor firms. In 2006, O'rourke was appointed as chief market strategist for BTIG.