The last stand of the equity bulls

May 24, 2011, 9:08 PM UTC

By Daryl G. Jones, Hedgeye

FORTUNE — What would General George Custer say about the recent stock market rally? I’m in the middle reading Nathaniel Philbrick’s book, The Last Stand, which is an account of Custer’s infamous defeat at the Battle of the Little Bighorn. Even a novice in American history knows the outcome of June 25th, 1876, a day in which the 7th Cavalry Regiment was soundly defeated by the combined forces of the Lakota, Northern Cheyenne, and Araphao people on the Montana plains.

Perhaps some of Custer’s early successes gave him some false confidence as it related to future military engagements. According to reports from The Battle of the Little Bighorn, General Custer reportedly said the following shortly before his death:

“Hurrah boys, we’ve got them! We’ll finish them up and then go home to our station.”

Reading the story of Custer and the Battle of the Little Bighorn made me think contextually about the stock market. In essence, I can’t help but wonder after a +95% move in the S&P500 from the lows of March 2009, whether this is “The Last Stand of the Equity Bulls.” Certainly, both price action and recent data suggests we are at a critical juncture. As well, and not dissimilar to Custer, there is likely an over confidence bias pervading the stock market due to the expedited two year move off the bottom. (LinkedIn anyone?)

Just like the cavalry, we’ve been sounding the warning trumpets of our key 2011 investment theme that accelerating inflation will lead to slowing growth. No doubt, we’ve been early sounding the trumpet, but the view is now playing out in spades.

A key element of this theme has been the price of copper, which is down just over 10% this year. Dr. Copper is perhaps one of the most predictive markets for gauging future economic growth, especially from China, a nation that consumes 40% of the world’s copper. In the most recent data from China, refined copper imports into China were down in April by 48% year-over-year and 17% sequentially from March. On the LME, copper inventories are up 34% from their December 2010 lows.

In other industrial metals, similar trends are in place. Lead inventories are up 53% this year to the highest level since February 1995, aluminum stocks are at near record highs and up 11% for the year, and zinc inventories are up 21% in 2011 and reached a 16-year high on May 18th. Other commodities are signaling the same via price action with lumber down 28% in price in the year-to-date, rubber down 7%, and coal down 6%. In aggregate, the commodity complex is clearly telling us that global growth is slowing.

While the most recent quarter of corporate earnings in the United States was decent, results, broadly, were characterized by margin compression. The bellwether indicator of cost inflation this quarter was Gap (GPS), which cut its full year earnings estimates from a range of $1.88 to $1.93 per share to a range of $1.40 to $1.50 per share due to “heavy cost pressure.” Collectively, the “cost issue” was reflected in the number of quarters that “beat” earnings this quarter. Incidentally, beats were down to the lowest level since Q4 2008 at 59.5%.

With a couple more quarters of FIFO accounting and tough commodity input compares ahead for the stock market, the valuation / earnings growth story becomes less compelling for equities, especially in the context of a slowing top line. Globally, slowing growth is being driven by the emerging world fighting inflation, with the most recent evidence being Chinese PMI coming in at a 10-month low. In Europe, slowing growth is and will continue to come from massive austerity measures that are being implemented to, hopefully, head off massive debt restructuring. While in the U.S., the consumer is facing a serious retrenching with U.S. average weekly earnings on a negative trend, unemployment numbers breaking out to the upside, and home prices continuing to be in freefall.

Despite the likelihood that corporate margins continue to compress in the coming quarters, which will continue the trends of slowing earnings momentum, those bullish on U.S. equities argue that yields on fixed income are so low that equities still offer a compelling risk / reward. On some level we agree, as we’ve already made the case for the Fed to remain indefinitely dovish
and James Bullard, the President of the St. Louis Fed, signaled as much when he said in a speech last night, “past behavior of the FOMC indicates that the Committee sometimes puts policy on hold.”

Being on hold is of course one thing, but not extending Quantitative Easing is quite another. It is the latter point that we believe the “The Last Stand of the Equity Bulls” is predicated upon. Unfortunately, given the fact that reported inflation in the U.S. is actually set to accelerate, it seems unlikely that the Fed will re-up on Quantitative Easing in the short term.

Hurrah, equity bulls! Hurrah!