Dow off 20 points yesterday. Gold down $6 an ounce. No biggie.

On Monday and Tuesday, we visited our youngest son, Edward, a sophomore at the University of Vermont. His roommate joined us for dinner.

“Okay, let me explain it to you,” we said.

The roommate was wondering if he should switch his major to economics.

“Economics is a phony science. The more you study it, the more you think you know… and the less you really know about how an economy actually functions.

“I’ll explain why in just a few sentences.

“If you are a real scientist, you start with things you can know… and you can build on them.

“Water boils at 212 degrees Fahrenheit at sea level, for example. The molecules heat up… then suddenly change from liquid to gas… and the pot boils. Right? Happens every time. You can count on it. And with this knowledge, you can build a steam engine.

“So, the simpleminded economist comes along and says, ‘Hey, an economy is like a pot of water! You heat it up… you get more activity… and GDP grows.’

“The analogy holds up superficially. You heat up the economy by putting some fire under it. If you’re a central banker, you lower interest rates. If you’re a politician, you increase the deficit.

“You know there’s a risk of overheating… or causing a bubble. But you think you understand how it works. You think you can predict and control the outcome because you’re a scientist who uses mathematical models, just like a real engineer.

Nobody Knows Anything

“But the problem is you don’t know anything. You don’t know if an economy really is like water. You don’t know where sea level is. For all you know, you’re high in the Alps. And you don’t know whether the fuel you’re using adds to the fire… or subtracts from it. QE, for example, may help heat up the economy. Or it may not. No one knows for sure.

“And get this. All those little molecules, you know – those individuals in the great economic pool? As soon as they catch on to what you’re doing, they will change their behavior. That’s the big difference between water and people. Water does the same thing no matter what you say or what you think. People don’t.

“We talk about the economy being like water. Well, try to imagine the contrary. Imagine water as though it was like a real economy. Imagine that the water knew you were going to bring it to a boil. Then instead of turning into vapor at 212 degrees, it might boil at 100 degrees or 170 degrees or 50 degrees in anticipation.

“And then, after you’ve brought it to a boil a few times, the water gets sick of being manipulated like this… and it boils off if it even suspects you’re thinking of warming it up.”

The kid started to fidget and look away. He was afraid he had run into some cranky old nut job who was going to keep talking all morning.

“Well, I guess I’ll stick with engineering.”

“Good idea.”

Regards,

Bill

Market Insight:

Earnings Estimates Fall… Stocks Rise

From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

Bill’s right. There’s very little we know about the economy…

For instance: What’s the relationship between inflation and employment?

Damned if we know!

Or: How many government bonds does the Fed have to buy to lift consumer prices by exactly 2.5% a year?

Who knows?

But there are some things we can count on more than others.

One of those things is the recurrence of bubbles. According to Charles Kindleberger, author of Manias, Panics and Crashes: A History of Financial Crises, a bubble involves “non-sustainable increases in the indebtedness of a group of borrowers or non-sustainable increases in the prices of stocks.”

As I wrote to members of Bill’s family wealth advisory service, Bonner & Partners Family Office (where I serve as investment director), by this definition it is reasonable to raise the question of whether the current rally in stocks is bubble-like.

There was a time when investors looked to underlying earnings to guide them on stock prices. If earnings were looking up, stock prices would rise. If earnings were looking down, stock prices would fall.

But as you can see from the chart below, of Q4 bottom-up earnings-per-share estimates gains in the S&P 500, this relationship has recently broken down.

According to data from FactSet, during October, analysts lowered earnings estimates by 1.5% in aggregate for the fourth quarter for the S&P 500. Despite the decline in earnings expectations, the value of the index increased 4.5% during the month.

This marked the seventh time in the past nine quarters that earnings estimates dropped and the value of the index rose during the first month of the quarter.

If earnings expectations are falling and the S&P 500 is rising, what is it that is keeping stock prices propped up?

Our guess: the widely held belief that QE4Ever will keep this merry dance continuing for quite some time.

Does that mean you should abandon caution and dive into US stocks at current prices? No. For long-term investors, the best time to buy stocks is when prices are low relative to underlying earnings.

Right now, that’s not the case.